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I low to read

a balance sheet
SECOND (REVISED) EDITION

International Labour Office Geneva


Second (revised) edition copyright © International Labour Organisation 1985

Publications of the International Labour Office enjoy copyright under Protocol 2 of the
Universal Copyright Convention. Nevertheless, short excerpts from them may be
reproduced without authorisation, on condition that the source is indicated. For rights of
reproduction or translation, application should be made to the Publications Branch
(Rights and Permissions), International Labour Office, CH-1 211 Geneva 22, Switzerland.
The International Labour Office welcomes such applications.

ISBN 92-2-103898-X

First published 1966


Fifteenth impression 1984
Second (revised) edition 1985

For permission to use copyright material in the preface and the glossary, grateful
acknowledgement is due to Hodder and Stoughton Ltd., publishers of Accounting reports
(London, 1970) by R.G.A. Boland and Di. Hall.

The designations employed in ILO publications, which are in conformity with United
Nations practice, and the presentation of material therein do not imply the expression of
any opinion whatsoever on the part of the International Labour Office concerning the
legal status of any country or territory or of its authorities, or concerning the delimitation
of its frontiers.
The responsibility for opinions expressed in signed articles, studies and other
contributions rests solely with their authors, and publication does not constitute an
endorsement by the International Labour Office of the opinions expressed in them.

ILO publications can be obtained through major booksellers or ILO local offices in many
countries, or direct from ILO Publications, International Labour Office, CH-1 211 Geneva
22, Switzerland. A catalogue or list of new publications will be sent free of charge from the
above address.

Printed in Switzerland
CONTENTS

Preface to the second (revised) edition VII

Technical data XI

How the programme works XIII

Progress work sheet XVII

Chapter I. Introduction
Set I. Some aspects of accounting I

Set 2. What is a balance sheet? 7

Chapter 2. The investment side of the balance sheet —


assets
Set 3. Types of assets and their liquidity 15

Set 4.. Valuation of assets 25

Chapter 3. The funding side of the balance sheet —


liabilities
Set 5. Current liabilities and fixed liabilities 41
Set 6. Shareholders funds 48
Set 7. Capital surplus and earned surplus; capital authorised
and capital issued 56

Chapter 4. The overall balance sheet


Set 8. Financial structure 69
Set 9. Sources and uses of funds 83

Chapter 5. Measuring solvency and liquidity


Set 10. Solvency 99
Set II. Liquidity 112

Chapter 6. Profitability
Set 12. The profit and loss account 127
Set 13. Two measures of profitability 136
Set 14. The valuation of an enterprise 145

Chapter 7. Assessing the balance sheet


Set 15. Reliability 155
Set 16. Limitations 165
V
How to read a balance sheet

Final quiz 173

Appendix A
Technical note on inflation accounting 187

Appendix B
Glossary i

Panel A facing 20
Panel B facing 21
Panel C facing 48
Panel D facing 49
Panel E facing 92
Panel X facing 93
Panel F facing 140
Panel Y facing 149

VI
PREFACE TO THE SECOND
(REVISED) EDITION
Accounting has been called the language of business. The balance sheet
and the associated financial reports are the principal devices for
presenting information about the financial position of a private or public
enterprise. Training in accounting and financial management has
therefore had a prominent place in the Management Development
Programme of the International Labour Office (ILO) since the l960s,
when the first edition of this book was published. The book quickly
became avery popular training and self-development text, translated into
more than 20 languages and used in over 90 countries.

The revised version of this programmed manual retains the essential


structure of the original text but includes several innovations to broaden
the scope of the programme, such as:
— new material on the profit and loss account and the sources and uses
of funds statement;
— a technical note on inflation accounting;
— a glossary of technical terms;
— shorter chapters with summaries;
— a final quiz to measure the knowledge acquired.

Purpose of the book

Although balance sheets are used throughout the world, their form and
the termsused in them vary from place to place according to national and
local customs and law. Furthermore, the interpretation of balance sheets
is directly related to the associated financial reports such as the profit and
loss account, the sources and uses of funds statement, the auditor's
certificate and the notes to the financial statements.

The subject is presented here in such a way that even people with limited
time for personal study will be able to master it easily. The programme
introduces the structure and language of a balance sheet (and of the
associated financial reports) and describes how the information given in
the various financial reports can be used to assess the financial position of
an enterprise. It also illustrates the structure of the resources of an
enterprise and explains the enterprise's responsibilities to, and relations
with, owners and other bodies.

Accountants, managers, directors, chairmen and shareholders in public


and private companies need to be able to interpret financial reports, as
do private investors, students of accounting, trade union officials, and
many persons concerned with the operation and supervision of
VII
How to read a balance sheet

public affairs at the local or national level. The growing emphasis on broad
consultation and on the popular understanding of development planning
may well extend the range of persons to whom such knowledge is useful,
especially now that enlightened enterprises in many countries provide a
considerable amount of information to their employees and to the
community.

Thus, this programmed text can be of use to a wide variety of readers. It


has been used with considerable success:
— in commercial colleges and schools;
— in the initial training of industrial, commercial and professional
accountants;
— in accounting and financial training for non-financial managers,
administrators, scientists, engineers, members of trade unions, and
others;
— in the training of management consultants;
— for individual study of basic accounting concepts;
— for group study (the programme is most efficient and effective when
learners help and motivate one another in pairs or in small
groups).

Accounting language

Like any language, the language of accounting can never express our
thoughts with absolute precision and clarity. This language is complex and
many of the words used do not mean the same as they do in everyday life.
We must learn to think of the accounting, rather than the popular,
meaning of such words.

Uncertainty

Accounting encompasses those facts about a business that can be


expressed in monetary terms. However, many important business facts,
such as the health of the management, the morale of the workers, the
state of the market, and so on, cannot be expressed in financial terms.
Accounting therefore provides only a limited picture of a business.

Accounting figures are thus only professional estimates, not scientific


facts. The key accounting concept is materiality, whereby
management concentrates on significant (material) values, with relatively
little attention to small amounts and small errors.
VI!!
Preface to the second (revised) edition

Conservatism

The practice of accounting arose from practical business activities over a


long period of time. In order not to mislead the managers of enterprises
(and in order to prevent them from having to pay more income tax than
absolutely necessary), accountants tended to be ultra-conservative
and to understate rather than overstate the financial position of a
business.

Accounting practices, therefore, aim to take profits only when they are
reasonably certain and yet, by contrast, to provide for losses as soon as
they are known or anticipated. An attitude of conservatism, however,
could lead to mis-statement of the financial position of a business; hence,
generally accepted accounting standards try to present a "true and fair
view" of a business.

Consistency and comparability

The basis of all profit is the accounting period during which the profit is
realised. Thus 10,000 units for a week is not the same as 10,000 units for
the whole year. Accounting figures are not significant in themselves but
only when they are compared with other figures for similar periods.
The accountant, therefore, despite the problems of uncertainty and
conservatism, tries to be consistent in his judgement so that the figures he
produces are comparable from one period to another.

Accounting and auditing standards

Generally accepted accounting standards are the concepts used to


convert accounting records into reliable accounting reports. In any
country such standards may arise from:
— the professional accounting associations;
— the legal establishment of an accounting plan (plan comptable),
especially in French-speaking countries, which sets out the required
accounting records, concepts and reports;
— income tax laws which may require different accounting concepts for
tax purposes; thus the balance sheet for income tax purposes (which
is often the published balance sheet) may show a highly conserva-
tive (understated) view of the financial position of the business
enterprise. Is this "true and fair"?
Similarly, generally accepted auditing standards are used for the
professional audit of accounting reports so that an "independent"
lx
How to read a balance sheet

professional auditor may give a 'clear" certificate. His certificate


generally states that the reports are prepared in accordance with
"generally accepted accounting standards" and verified in accordance
with "generally accepted auditing standards" to show a "true and fair
view" of the business enterprise.

Efforts to achieve internationally acceptable accounting and auditing


standards are seriously handicapped by variations in economic, political
and legal environments, and by differing objectives for accounting in
various countries.

Acknowledgements

The original version of this book was prepared by J. J. H. Halsall, FCA,


formerly of the ILO Management Development Branch, who was
responsible for the accounting aspects of the text in association with
Learning Systems Ltd. In 1984 the book was extensively revised and
rewritten by Robert A. Boland, FCA, Ph.D., of the ILO Management
Development Branch, assisted by Richard Oxtoby, Ph.D., and Catherine
d'Arcangues, Ph.D., consultants.

Many accounting and management development professionals working


with the ILO Management Development Programme have helped us
by providing useful comments and testing the manual. Without their
contribution, the publication and wide application of this manual would
not have been possible.

x
TECHNICAL DATA

Type of programme

Linear — that is, the programme is to be done set by set and chapter by
chapter. Difficulties should be resolved by repeating the sets and by using
the glossary.

Estimated completion time

While you will work at your own pace, the results of our pilot tests
indicate that most people complete this programme (including the
mini-tests and the final quiz) in eight to 16 hours.

Testing

The original programme was extensively field-tested by members of the


target population in various countries and regions with satisfactory
results. However, the International Labour Office would welcome further
reports from users who have worked through this revised edition.

Appendices

The technical note on inflation accounting contained in Appendix A may


be useful to students for reference at a later stage. A glossary of some of
the accounting terms used in different parts of the world is to be found in
Appendix B at the end of the book. Students may like to make their own
additions to the glossary as they come across further accounting terms
and alternative expressions.

Presentation of balance sheets

The presentation of figures on balance sheets and on other financial


statements varies from one enterprise to another. On the balance sheets
in this book, amounts over 999 are presented without a comma, but in
the text itself a comma is inserted.

Suggested uses for the programme

The programme can be used:


(a) for individual study;
(b) as a back-up to training in management and accounting centres;
(c) for group study — the programme is most effective when learners help
and motivate one another in pairs or in small groups.

Xl
HOW THE PROGRAMME
WORKS
I. Tear off the flap at the front of the book and use it as a mask to cover
the left-hand column of this page.

2. Read Frame A carefully and write the missing word in the last
column.

3. Move the mask down and check your answer.

4. Then read Frame B and write the missing words in the right-hand
column, and so on.

5. Whenever you turn a page, mask the whole column at once and slide
the mask down only after you have written your answer in the last
column.

CHECK FRAME YOUR ANSWER

Is your answer A. In this programme you will often be


right? Check below, asked to fill in missing words as you go
along. Sometimes you have to write one
word, and sometimes more than one.
Where there is one dash you write
word.

A B. Where there is one dash you write


one one word. Where there are two dashes
you write Sometimes
these two dashes may be joined by a
hyphen to indicate a hyphenated word.

B C. Just occasionally you will have to fill


two words in more than two words. In this case there
will be a row of dots. Where there is a
row of dots you write
How to read a balance sheet

CHECK FRAME YOUR ANSWER

C D. Going back for a minute: one dash


more than two calls for word; two dashes call
words for and a row of dots
means that you have to fill in

D E. When square brackets containing


one two or three words or phrases are .

two words separated by oblique strokes, you, should


more than two select the right word or phrase. For
words example: This book is [a conventional
textbook/a new type of textbook].

E F. When several alternatives are given


a new type of in the following way:
textbook (a) this sentence contains four words;
(b) this sentence contains five words;
(c) this sentence contains six words;
you should choose the correct alternative
and write (a), (b) or (c) in the answer
column.

F G. Before you start on the programme


(b) itself, note that you don't have to guess to
get the right answers. Read the frames
carefully and they will give you the
information which you need to get the
r________ answers. In this case the r"
before the dash means that the missing
word which you have to fill in begins with
an

G H. Don't hesitate to write a word


right because you think that it is too simple
or obvious. The whole idea of this
programme is that it moves in easy
steps. You never have to g the
answers.

xlv
How the programme works

CHECK FRAME YOUR ANSWER

H I. A reminder: Where one word is


guess wanted there will be dash. Two
dashes mean that you should write
A row of dots means
that you should write

I
J. Where there are square brackets
one containing two or three words or
two words phrases, you should [choose the correct
more than two word or phrase/simply read them].
words

J K. When several alternatives are


choose the correct given:
word or phrase (a) copy the whole sentence;
(b) choose the incorrect alternative;
(c) choose the correct alternative;
choose the correct alternative and write
(a), (b) or (c) in the answer column.

K L. Finally, the correct way to go


(c) through the programme is:
(a) read the frame and fill in the missing
word, , or

or choose the [correct/incorrect]


word or phrase;
(b) move the mask down so that you can
read the r answer,
(c) go on to the next f_______

L Now start working through the pro-


(a) one gramnie itself.
two words Read each frame carefully before writing
more than two anything.
words
On turning over each page, remember
correct
to cover up the left-hand column with
(b) right
the mask before going on to the next
(c) frame
frame.

xv
How to read a balance sheet

IMPORTANT NOTE

Read each frame carefully. If you do not understand something the


first time, read the frame again before going to the next one. Do
not spend too much time on any one frame; the programme
deliberately repeats all the key points to be learned.

Do not hesitate to repeat the frames and answers aloud if it helps


you to learn better. Try to work quickly and repeat a whole set
again if you feel uncertain. Use the glossary for difficult technical
terms.

Go on steadily set by set and never start a new set when you are
tired. Do not try to do too much in one sitting but make time
available to finish the whole programme over a few days; repeat it
as necessary.

Working in pairs or in small groups is recommended; it makes the


work more interesting and improves the quality of the learning.

xv!
PROGRESS WORK SHEET

Chapter/Set Estimated time Actual time Total Frames Frames


(minutes) (minutes) frames right wrong

Chapter I Set I 10 20
Set2 15 25
Study
glossary

Chapter 2 Set 3 25 50
Set4 25 50
Mini-test 20 20

Chapter 3 Set 5 20 39
Set6 5 35
Set7 5 30
Mini-test 20 20

Chapter 4 Set 8 30 64
Set9 20 45
Mini-test 20 20

ChapterS Set 10 25 40
SetlI 20 41
Mini-test 15 20

Chapter 6 Set 12 20 40
Set 13 20 50
Set 14 10 IS
Mini-test 20 20

Chapter 7 Set IS 25 52
Set 16 20 22
Mini-test 10 10

Final quiz 50 60

Totals 470 788

'If your English is not fluent, you may need to add up to I 00 per cent to each of the estimated
times.
XVII
INTRODUCTION I

I. SET I. SOME ASPECTS OF ACCOUNTING


Estimated time: 10 minutes

Summary

There is no set of detailed rules that is universally agreed upon for drawing
up the financial statements of a business enterprise. As a result, balance
sheets of different business enterprises (especially if they are from
different countries) may differ in detail from each other. The basic
principles are always the same, however, and all balance sheets have
something in common.

Accountants drawing up balance sheets are sometimes required to


make judgements about monetary values. The criteria they choose are
important, but it is even more vital that the accountants should be
consistent in using them.

Accounting figures are not significant in themselves. They are significant


only when compared with other similar sets of figures. The significance
(or materiality) of accounting figures depends very much on the date or
time period to which they refer.

To be useful and reliable, financial statements should be timely and should


be professionally audited.

IMPORTANT NOTE

At the start of each set there is a summary (as above) of the


technical terms and ideas to be learned from the set.

If you already understand all of the summary, do not complete the


set, but pass on to the next one.

If you do not completely understand every technical term and idea


in the summary, do the whole set. Do not attempt to do only parts
of a particular set.
How to read a balance sheet

CHECK FRAME YOUR ANSWER

(Don't forget to cover up the left-hand


column of each page with your mask and
to move the mask down to check your
answer before going on to the next
frame.)
Is your answer I. Balance sheets are produced by
right? Check below, accountants. Before we start to look at
the sheet itself, let us look at
a few general features of accounting
practice which should be borne in mind as
you work through this book.

I 2. Accountants have different opinions


balance on many subjects — within the field of
accounting as well as outside it. So it is not
surprising that there are some variations
in practice to be found in
different countries, in different parts of
the same country, and even between
different working in the same
place at the same time.

2 3. This means that there is no single,


accounting universally accepted form for the pres-
accountants entation of those financial statements
which an accountant produces to
describe the financial situation of a
b enterprise. Individual differ- .

ences among accountants result in dif-


ferent forms of presentation of
statements.

3 4. Despite these d there are


,

business some basic principles which are generally


financial accepted. By the time you have finished
working through this book, you should
have a good knowledge of these basic
principles.

2
introduction

CHECK FRAME YOUR ANSWER

4 5. However, don't be surprised if you


differences come across a balance sheet some time
which does not look exactly like those
you will see in this book. Different
balance sheets may differ in the detail of
their presentation, but they all follow the
same basic

5 6. One reason for the differences in


principles accounting practice is that it is difficult to
assess accurately some of the monetary
values which appear on the balance sheet.
A balance appears to be a very
"definite" statement about various sums
of money.

6 7. This apparently definite" statement


sheet may, however, be deceptive. Many of the
figures appearing on a balance sheet are
estimated by the a

7 8. For example, whit is the value today


accountant of the land and buildings which a business
enterprise bought 50 years ago? The land
may well have increased in value but the
value of the buildings has probably
d_______ as a result of decay and the
wear and tear of 50 years of use. The
accountant must decide what to
put on them on the balance sheet.

8 9. Or take the example of a business


decreased enterprise which buys goods for resale.
value When does it actually make a profit on a
particular item: when it receives the
item into stock, when it receives the
customer's order for that item, when it
dispatches the item to the customer, or
when the customer finally pays the
account? Again, there is uncertainty and
the has to make a judgement.

3
How to read a balance sheet

CHECK FRAME YOUR ANSWER

9 10. Most of these judgements are made


accountant in terms of generally accepted accounting
practices, as you will see later in this book.
Bear in mind, however, that many of the
apparently precise figures appearing on a
are estimates made by
the accountant who drew it up and that
different accounting may be
followed in different parts of the world
and at different times.

10 II. However, the particular criteria an


balance sheet accountant uses in making a judgement
practices are not so important as the need for the
accountant to be consistent in using the
same r on different occasions.

II 12. Accounting figures are not sig-


criteria nificant in themselves. Thçy are only
significant when compared with other
for a similar previous period, for
a budget estimate, or even for another
business enterprise.

I2 13. Accountants therefore, despite the


figures problem of uncertainty, try to be
in their judgement, so that the figures
they produce are comparable from one
period to another.

13 14. Another point we need to consider


consistent in this introduction is the importance of
time periods and dates in assessing the
significance of the information contained
in f_______ statements.

4
Introduction

CHECK FRAME YOUR ANSWER

14 15. Sometimes the financial position


financial of a business enterprise changes
dramatically in a very short space of
The position on June 30 may be
very different from what it was on
January I.

IS 16. Again, a certain sum of money may


time represent a very significant (material)
profit if it was made over one month, but
may represent a very poor profit for one
whole year. In assessing the significance
(materiality) of the figures contained in a
balance sheet or in any other financial
statement, it is essential to know the
period or to which they
refer. Incidentally, what kind of chair
would be a 'material" asset?

16 Il. Financial statements describe the


time financial situation of a business enterprise
date over time. They are used by the different
An antique chair parties who have relations with the
which is of enterprise, including management, trade
significant value unions, government, creditors, banks
and shareholders. To be useful, the
statements should contain up-to-date
information; they must therefore be
[timely/delayed].

17 18. To be useful, financial statements


timely should be:
(a) timely and reasonably accurate;
(b) absolutely accurate, no matter how
late;
(c) delayed for as long as possible.

5
How to read a balance sheet

CHECK FRAME YOUR ANSWER

8 19. Most financial statements cover a


(a) period of one year — so how soon after
the end of the year do you think they
should be available in order to be
"timely"?
(a) within 3 months;
(b) 4 to 6 months;
(c) 7 to 12 months;
(d) 13 to 48 months.

19 20. Now, financial statements may also


(a) be submitted to an auditor for an
independent professional opinion on the
judgements made by the accountant. Are
such audited reports more reliable?

20 You have now reached the end of the


Yes general introduction. Note how long you
took to complete this set and the number
of wrong answers you gave. Enter these
on the Progress Work Sheet on page
XVII. Then turn to the summary at the
beginning of this set and read it through
again before moving on to Set 2.

6
Introduction

I. SET 2. WHAT ISA BALANCE SHEET?


Estimated time: 15 minutes

Summary

A balance sheet is a statement of those assets and liabilities of a business


enterprise that can be given a value in terms of money; it shows both the
assets and how the assets are financed; the figures are estimates, not
scientific facts.

The liabilities indicate what money has been made available to the
enterprise, and from where.

The assets show how the enterprise has used the money made available
to it.

Total assets must always equal total liabilities to creditors and


shareholders.

Every balance sheet must include the name of the enterprise and the date
to which the figures in the balance sheet refer.

The balance sheet is one of the financial statements of a company and


needs to be supported by:
(a) the profit and loss account (income statement);
(b) the sources and uses of funds statement (funds flow statement);
(c) notes to the financial statements;
(d) the auditor's certificate.

7
How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. A balance sheet may look rather


right? Check below, complicated but basically it is a simple
statement about a business enterprise.
Most business enterprises produce
statements at regular intervals showing
what they own and what they owe.
A balance sheet is a statement of what
an enterprise and what it
at a particular date.

I 2. The things that a business enterprise


owns owns are called its assets.
owes The various sums of money that a
business enterprise owes are called its
liabilities.
Would a company's buildings and
manufacturing tools be classed as assets
or as liabilities?

2 3. Assets include land, buildings, manu-


Assets facturing equipment, motor vehicles,
fixtures and fittings and anything else an
enterprise o_______ that can be given a
value in terms of money.
Can the stocks of raw materials held by
a manufacturing company be given a
value in monetafly terms?

3 4. Stocks of raw materials (and finished


owns products) are things owned by an
Yes enterprise that can be given a value in
terms. They are classed as

8
introduction

CHECK FRAME YOUR ANSWER

4 5. Now, to acquire its assets, an


monetary enterprise must obtain money from
assets various sources; for instance, it may
borrow from loan companies or from
banks. It then o_______ this money.

5 6. The various amounts of money owed


owes by an enterprise are cafled its

6 7. As well as borrowing from banks and


liabilities other sources, many companies obtain a
good deal of the money that they need
from their shareholders.
The shareholders of a company gen-
erally subscribe, or make money avail-
able, for the life of the

7 8. Such money is known as share-


company holders' funds, and is subscribed for the
life of the company; it will be repaid to
the shareholders only if the company is
wound up. Nevertheless, the money is
still o_______ to the shareholders.

8 9. The money that is subscribed by


owed shareholders is in fact to the
shareholders, and it is therefore part of
the company's [assets/liabilities].

9 10. Balance sheets may be set out in


owed different ways, but however they are set
liabilities out, they always show the and
of the enterprise concerned.

9
_______. _______.______.
_______ _______

How to read a balance sheet

CHECK FRAME YOUR ANSWER

l0
assets
liabilities HANDICRAFTS LTD.
Balance sheet at 31 December I 984
(expressed in "world currency units" (WCU))

ASSETS LIABILITIES
Raw materials, etc. 6 920 Bank overdraft 4 300
Land, buildings, etc. 17 500 Long-term mortage loan
owed to loan company 14 000
Money subscribed by
shareholders 6 120
Total assets Total liabilities

I I. Here is a very simple balance sheet.


This balance sheet shows the assets and
liabilities of (whom?) at

(date). Both the assets and the liabilities


are expressed in m_______ terms. Fill in
the two missing totals on the balance
sheet. Are these totals
the same or different?

Il 12. The name "balance sheet" comes


Handicrafts Ltd. from the fact that the total
31 December 1984 always equal the total In other
monetary words, they b_______ each other.
24,420, 24,420
Same

12 13. Let us see why the total assets and


assets the total liabilities are in balance. Look
liabilities at the balance sheet of Handicrafts Ltd.
balance again. The bank, the loan company, and
the shareholders have all made money
available to the company.
In other words, the [assets/liabilities]
on the balance sheet show what money
has been made available to the company
from various sources.

10
Introduction

CHECK FRAME YOUR ANSWER

13 14. Now, an enterprise obtains money


liabilities with the object of employing it: for
instance, to buy raw materials, etc.
We can see how an enterprise has
employed or used its money by looking at
the on the balance sheet.

14 15. The liabilities, then, show what


assets has been made available to the
enterprise, and the show how
this money has been used.

IS 16. The total assets and the total


money liabilities will be equal because the
assets show the money that has been
made available to the enterprise and
the show how this money is
employed by the enterprise.

l6
liabilities
assets
Balance sheet
(expressed in WCU)

ASSETS LIABILITIES
Raw materials, etc. 12 000 Bank overdraft 7 200
Land, buildings, etc. 20 800 Long-term mortage
loan owed to
loan company 10000
Money subscribed
by shareholders 15 600
Total assets 32 800 Total liabilities 32 800

17. Here is another simple balance


sheet. Look at it carefully and compare
it with the one in frame II.
This new balance sheet has two things
missing. These are

II
How to read a balance sheet

CHECK FRAME YOUR ANSWER

17 18. If you are looking at a balance sheet


the name of the in order to assess the current position of a
enterprise, and the particular enterprise, it is obviously most
date of the balance important to make sure that you have the
sheet balance sheet for the right enterprise.
You will also want to know whether
you are looking at the most recent
balance sheet.
The first two things to look for on a
balance sheet, then, are the of
the enterprise and the of the
balance sheet.

18
name
date
HANDICRAFTS LTD.
Balance sheet at 31 December 1984
(expressed in WCU)

ASSETS L!ABILITIES
Raw materials, etc. 6 920 Bank overdraft 4 300
Land,buildings, etc. 17500 Long-term mortage
loan owed to
loan company 14000
Money subscribed
by shareholders 6120
Total assets 24420 Total liabilities 24420

19. Now look at the balance sheet that


is given above. Does it convey the same
information as that given on the balance
sheet in frame I I

19 20. Balance sheets can be set out in


Yes many different ways. But, however they
may vary in detail, balance sheets should
always include two main groups of
figures: the and the,

12
Introduction

CHECK FRAME YOUR ANSWER

20 21. It is important to note before


assets finishing this section that many of the
liabilities factors which affect the position of an
enterprise cannot be expressed in
monetary terms. For instance, a company
might be fortunate in having a highly
trained and stable labour force, or some
major political change may be coming.
Are factors like these indicated on a
balance sheet?

21 22. Now, we said in the summary that


No the balance sheet must be associated with
(Such factors are other financial statements, such as the
indicated in the profit and loss account, the sources and
notes to the financial uses of funds statement, notes to the
statements.) financial statements and finally the
certificate.

22 23. If we cannot find the information


auditor's we need on the balance sheet, the profit
and loss account, the sources and uses
of funds statement or the auditor's
certificate, then the last place to look is in
the to the financial statements.

23 24. All of these associated financial


notes statements will be discussed later in the
programme. At this stage you must just
recognise that the balance sheet alone
[is/is not] sufficient.

24 25. Incidentally, is a very small antique


is not chair a "material asset"

25 That is the end of the second set. Note


Yes, if it is of the time you took to complete this set and
significant value! the number of frames in which you made

13
How to read a balance sheet

CHECK FRAME YOUR ANSWER

a mistake, and enter these details on the


Progress Work Sheet.
Normally there is a review in the form
of a mini-test after each chapter. How-
ever, for this chapter you should explore
the glossary in Appendix B. Look up
"accounting concepts" in the glossary
and then find the definition of each
concept. Finally, read the summary at the
beginning of each set in the chapter once
again before going on to the next
chapter.

14
THE INVESTMENT SIDE OF 2
THE BALANCE SHEET ASSETS -
2. SET 3. TYPES OF ASSETS AND THEIR LIQUIDITY
Estimated time: 25 minutes

Summary

The assets of a business enterprise are usually listed on a balance sheet in


two main groups: fixed and current.

Fixed assets are acquired for long-term use in the enterprise, do not vary
greatly from day to day, and are only infrequently converted into cash
during the life of the enterprise.

Current assets generally include cash, customers' accounts and in-


ventories that will be converted into cash during the operating cycle of the
business; they are likely to vary continually.

Liquidity refers to the ease with which assets can be converted into cash;
thus, current assets are more liquid than fixed assets.

Those current assets that can be most quickly converted into cash are
known as quick assets.

Panel A at page 20 lists the assets schematically.

Is
How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer CURRENT ASSETS AND FIXED ASSETS


right? Check below I. First a reminder: the liabilities on
a balance sheet show what money, or
finance, has been made available to the
enterprise from various sources, and the
assets show how this money is

I 2. In simpler terms, the assets are what


employed (or used) an enterprise o , and the liabilities
are what it o_______

2 3. Now a company may not only


owns money to others, but may itself
owes be owed money by other people. At any
one time it will probably have customers
who have not yet paid for goods
or services which they have already
received.

3 4. Although this money has not yet


owe been received by the company, these
"customers' accounts" would always be
listed on a balance sheet under the
[assets/liabilities].

4 5. What we have referred to here as


assets "customers' accounts" is sometimes
referred to as "debtors" or "accounts
receivable". Thus, debtors or accounts
receivable would appear on the balance
• sheet under the

5 The balance sheets in Set 2 gave very


assets short lists of assets. Panel A gives an
example of the kind of list of assets which
you might find on a balance sheet. Before
proceeding with frames 6 to 26, open out
Panel A (page 20).

16
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

6. Assets are usually listed on a balance


sheet in two main groups: assets
and assets.

6 7. Look at the two groups again. One of


current them is a list of assets which are generally
fixed intended for use in the business over a
relatively long period. Which would you
say are the long-term assets: the current
assets or the fixed assets?

7 8. Assets which are generally intended


Fixed assets for use over a long period include land,
buildings
(give two others). They are called
assets.

8 9. Look at the two groups of assets


plant and again. Which group is not likely to vary
machinery, motor greatly in quantity from day to day: the
vehicles, fixtures current assets or the fixed assets?
and fittings .

(any two)
fixed

9 10. Fixed assets are acquired for


Fixed assets use in the business. They
[are likely/are not likely] to vary greatly in
quantity from day to day.

10 II. Without looking at Panel A, see if


long you can write down three of the items
are not likely you might find listed on a balance sheet
under fixed assets

'7
How to read a balance sheet

CHECK FRAME YOUR ANSWER

II 12. Now look at the list of current


Land, buildings, assets in Panel A. Unlike fixed assets,
plant and current assets are [intended/not
machinery, motor intended] for long-term use in the
vehicles, fixtures business.
and fittings (any
three) .

12 13. Are the current assets likely to vary


not intended in quantity from day to day?

13 14. Assets intended for comparatively


Yes long-term use in the business are called
assets.

14 (5. Current assets include cash and


fixed assets which will normally be converted
into c during the operating cycle
of the business.

IS 16. In the case of a manufacturing


cash company, the operating cycle is the
period between buying the raw materials
and selling the finished products. The
operating cycle of most businesses is
usually less than one year.
Current assets, then, include cash and
assets which will normally be converted
into cash [in the long term/in less than
one year].

16 17. Current assets, then, represent


in less than one year employment of money on a short-term
basis.
Fixed assets, on the other hand,
represent the employment of money on a
basis.

18
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

17 (8. On a well-prepared balance sheet,


long-term money employed on a long-term or a
short-term basis is shown as fixed assets
or current assets [together/in separate
groups].

18 19. Assets which are likely to be con-


in separate groups verted into cash during the operating
cycle of the business are classed as
assets.

19 20. Now, the operating cycle of a


current manufacturing company is the period
between buying the and
selling the

20 21. Stocks of finished products are


raw materials likely to be sold and therefore to be
finished products into during the
cycle.

21 22. Stocks of finished products, raw


converted materials and work in progress are
cash all assets. Such stocks are
operating sometimes referred to as "inventories".

22 23. Customers' a are likely to


current be paid and therefore converted into
cash. They are classed as
assets.

23 24. Marketable securities generally


accounts represent short-term investment by the
current company of its surplus money. They are
referred to as "marketable" because they
[can/cannot] readily be sold, should the
need arise.

'9
How to read a balance sheet

CHECK FRAME YOUR ANSWER

24 25. Marketable securities are generally


can classed as assets because they
can readily be

25 26. Look at the list of assets in Panel A..


current The item below customers' accounts is
sold

26 Now fold Panel A away.


deposits 27. When companies make contracts
they often have to deposit money as
a guarantee that they will fulfil the
contracts. These deposits will normally be
returned later in cash and are therefore
included in the

27 28. Stocks of raw materials are likely to


current assets be processed and sold during the
cycle of the business. They are classed as

28 29. Fixed assets, on the other hand, are


operating not generally acquired with the object of
current assets being sold. They are generally acquired
for use in the
business.

29 30. Here is a short mixed list of assets:


long-term finished products, customers' accounts,
land, marketable securities, plant and
machinery, cash in banks, raw ma-
terials.
Indicate which of the items are current
assets and which of them are fixed assets
by putting them in two lists under their
proper headings

20
PANEL A

TABLE OF ASSETS LISTED SCHEMATICALLY

Cash in banks
Cash in hand
Quick assets
(most liquid)
- Marketable securities (investments)
Customers' accounts (or debtors or
accounts receivable)
Deposits
Current assets Employee accounts (advances to
employees)
Other accounts outstanding
Prepaid expenses (rent paid in
- advance, etc.)

Finished products
Work in progress (semi-finished
- Inventories
products)
(or stocks)
Raw materials
Other supplies

— Land
Buildings
Fixed assets
Plant and machinery
(least liquid)
Fixtures and fittings
— Motor vehicles

PANEL B — overleaf
_______

PANEL B

HOUSEHOLD UTENSILS LTD.


Balance sheet at 3! December 1983 (expressed in WCU)

ASSETS LIABILITIES

Current assets
Cash in banks — Owed to trade
Cash in hand 250 creditors, etc. 177 970
250
Marketable securities
(market value 2 100) 2000
Customers accounts 261 000
Deposits 550
Employee accounts I 200
Other accounts 3I5 Long-term loans 58 890
Prepaid expenses (rent
paid in advance, etc.,) 200
265 265
Less: Provision for
doubtful items I I 415
253 850
Inventories, at cost or
current market value,
whichever is the lower: Invested by
Finished products 30 500 shareholders 119740
Work in progress I 200
Raw materials 50 100
Other supplies 600
82400
Less: Provision for
inventory losses I 100
81 300
Total current assets 335 400

Fixed assets
Land, at cost I 600
Buildings, at cost II 000
Plant and machinery, at cost 8 800
Motor vehicle, at cost I 200
Fixtures and fittings, at cost 2 200
24 800
Less: Depreciation 4 600
20 200
Goodwill, at cost I 000
Total fixed assets 21 200
Total assets 356 600 Total liabilities 356 600
The in vestment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

30 31. Here is a list of assets. One of


Current: cash in the items is under the wrong heading.
banks, marketable Indicate which one it is.
securities,,
CURRENT
customers
accounts, finished cash

products, raw marketable securities


materials customers' accounts
Fixed: land, plant raw materials
and machinery deposits
prepaid expenses

FIXED
land
buildings
finished products
machinery
motor vehicles
fixtures and fittings

3I 32. Finished products are


finished products assets. They are likely to be and
therefore converted into cash during the
operating cycle of the business.

32 LIQUIDITY OF ASSETS
current 33! In theory all assets could be
sold converted into cash, though normally the
assets would not be sold to raise
cash.

33 34. Fixed assets are generally intended


fixed for long-term in the

34 35. An informative balance sheet will


use list the assets in order of liquidity, i.e. the
business order in which they could most easily be
converted into

2!
_______

How to read a balance sheet

CHECK FRAME YOUR ANSWER

35 36. Here is the list of assets that you


cash saw before:
CURRENT ASSETS
(I) Cash in banks
Cash in hand
(2) Marketable securities
Customers accounts
Deposits
Employee accounts
Other accounts outstanding
Prepaid expenses
(3) Finished products
Work in progress
Raw materials
Other supplies

FIXED ASSETS
(4) Land
Buildings
Plant and machinery
Fixtures and fittings
Motor vehicles

These assets are arranged in four groups,


from the most to the least
liquid.

36 37. The fixed assets, then, are the


liquid liquid of the assets.

37 38. The most liquid single asset of all, of


least course, is

38 39. Stocks of finished products, work in


cash progress and raw materials are [more
liquid/less liquid] than customers' ac-
counts and marketable securities.

39 40. List the following assets in order of


less liquid liquidity, starting with the most liquid:
raw materials, cash in hand, buildings,
marketable securities.

22
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

40 QUICK ASSETS
cash in hand (I) 41. Current assets are more liquid than
marketable assets.
securities (2)
raw materials (3)
buildings (4)

41 42. At the same time some current


fixed assets are liquid than other
current assets.

42 43. In fact some of the current assets


more (or less) are known as quick assets because they
can be q converted into cash.

43 44. Cash, of course, is also a


quickly .

44 .45. Customers' accounts can generally


quick asset be converted into cash at short notice.
Customers' accounts are part of the
group of current assets which are known
as

45 46. securities are part of the


quick assets because they can be sold
at short notice.

46 47. The main quick assets, then, are


Marketable , and
quick assets .

47 48. Deposits, employee and other


cash accounts, and prepaid expenses are also
customers' accounts sometimes included under quick assets
marketable because generally they can be
securities within a reasonably short period.

23
How to read a balance sheet

CHECK FRAME YOUR ANSWER

48 49. Inventories, or stocks, of finished


converted into cash products cannot be sold unless someone
is willing to buy them. It [is/is not] always
possible to sell them at short notice.

49 50. Inventories of finished products


is not [are/are notJ part of the quick assets.
Again, inventories of raw materials and
work in progress may have to be
processed before they can be sold and
converted into cash. They [are/are not]
quick assets.

50 And that brings us to the end of the third


are not set. Note the time you took to complete
are not the set and the number of frames in which
you made a mistake, and enter these
details on the Progress Work Sheet.
Then read the summary at the beginning
of this set once again before going on to
the next set.

24
______________________

The investment side of the balance sheet — assets

2. SET 4. VALUATION OF ASSETS


Estimated time: 25 minutes

Sum mary

The valuation of assets is always an estimate. The relevant accounting


concepts for such estimates of value are described in the "generally
accepted accounting standards" of a country. In some countries such
standards are required by law.
The general rule is to be cautious. If there is a choice between a higher
or lower value of an asset, almost always choose the lower value.
Current assets are generally valued at cost or market value, whichever is
the lower.
Fixed assets are generally valued at cost or revaluation, less accumulated
depreciation.
The figure below shows how each of the assets in Panel A is valued.
VALUATION OF ASSETS

TYPE OF ASSET NATURE OF ASSET HOW VALUED

rCash in banks at cost (foreign currency


F valued at current
[1 Cash in hand
J exchange rates)

Quick s —l
at cost or lower
Marketable securities
(most liquid) .5 realisable value
I

Deposits
LJ Prepaid expenses (e.g. rent)
]- at cost

I
Customers' accounts 1 at full value less
— Current assets
I
Employee accounts provision for doubtful
L Other accounts outstanding I items

r Finished products at cost or current


Work in progress market value,
Inventories I

Assets — F whichever is
(or stocks) Raw materials
I
the lower, less
L Other supplies I provision for losses

Land at cost or valuation

- Fixed assets Buildings


(least liquid) Plant and machinery at cost less
Fixtures and fittings depreciation
Motor vehicles ]
25
How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. In this set we are concerned with the


right? Check below, monetary values that are shown on a
balance sheet against the different kinds
of

I 2. As we pointed out earlier in the


assets introduction, the valuation of assets is not
always a simple matter. With some
assets, for example, there could be a
choice between showing them on the
balance sheet at what they cost, and
showing them at their current market
value. Would cost and current market
value always be the same?

2 3. If assets are overvalued (shown as


No too high a value on the balance sheet),
this could mislead shareholders and other
interested persons into believing that the
company is worth more than it is. To
protect shareholders and others, the laws
of some countries specify how the assets
should be

3 4. In any case, however, a sensible


valued accountant will be cautious in valuing
assets. Where there is a choice between a
higher and a lower figure, the accountant
will choose the figure.

4 Open out Pane! B (page 21) which gives a


lower partial balance sheet and includes the list
of assets that you saw before. There are a
few new items on the list; some of them
are shown in heavier type.

26
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

5. Look at the figures on the balance


sheet in Panel B. The total assets are
valued at_______ the total current assets
are shown at this includes
for cash, for the other
quick assets, and for the
inventories (or stocks).

5 6. Look at all the entries in heavier type


356,600 on the balance sheet in Panel B. They
335,400 all [increase/reduce] the value of the
250 assets.
253,850
81,300

6 7. Note that the only asset, apart from


reduce 'goodwill", which is not reduced in some
way is the

7 . VALUATION OF QUICK ASSETS


cash 8. Quick assets, remember, include
and other assets that can be
converted into cash.

8 9. Quick assets [include/do not include]


cash inventories of finished products and
quickly other stocks. They usually [include/do
not include] marketable securities,
customers' accounts and other ac-
counts.

9 10. Look again at Panel 8. The total of


do not include quick assets is +
include

27
How to read a balance sheet

CHECK FRAME YOUR ANSWER

10 II. Look at the quick assets again. The


250 figure shown against customers' accounts
253,850 is (how much?). This is the
amount actually o_______ to the
company by its customers.

II 12. How much money is owed to the


26 000 company by its employees?
owed

12 3. Can the company be certain that it


1,200 could quickly recover all the money owed
to it by customers, employees and other
debtors?

13 14. It is never certain that all accounts


No will be fully paid. The-company has been
cautious and allowed for this fact. One of
the entries in heavier type shows that
the value of the customers' accounts
and other accounts has been
[increased/reduced] by (how
much?) to allow for accounts that may
never be converted into cash.

14 15. The total value of the quick assets


reduced on the balance sheet is
11,415

15 (6. Look at the quick assets in, Panel B


254,100 (250 + once more. The company's marketable
253,850). (Note securities have been shown at
that there are (how much?). This represents their
separate totals for [cost/market value].
cash and for the
other quick assets.)

28
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

16 17. Marketable securities could be


2,000 shown at either cost or current market
cost value. However, the market value of
these securities can fluctuate widely and
so they are usually shown on balance
sheets at

17 18. Marketable securities are usually


cost shown at cost, but the balance sheet
should indicate their current

8 19. There is one other adjustment that


market value sometimes has to be made to the values
given to the quick assets. Normally, quick
assets in the form of cash do not have to
be adjusted in value. But suppose part of
the money is held in foreign currency. In
this case the rates of exchange will vary
from time to time, and so the v______ of
the c will also vary.

19 20. Cash assets, then, sometimes have


value to be adjusted in value when the cash is
currency or cash held in
Incidentally, do you think a fast car is a
"quick asset"?

20 VALUATION OF INVENTORIES
foreign currency 21. Inventories, or stocks of finished
No! products, partly finished products, raw
materials, etc., are part of the
assets.

21 22. Inventories [are/are not] regarded


current as part of the quick assets.

29
How to read a balance sheet

CHECK FRAME YOUR ANSWER

22 23. Until manufactured goods have


are not actually been sold, can a company be
quite certain that it will make a profit on
them?

23 24. A company can never be absolutely


No certain in advance that it will make a
profit on the sale of its goods. It would
therefore be unwise to value its in-
ventories at greater than their original
cost. Suppose, however, that the market
value of the inventories at the date of the
balance sheet is less than cost. In this case
a cautious management will value its
inventories at [cost/market value].

24 25. Thus, inventories of raw materials,


market value finished products, etc., are usually valued
at cost or current market value,
whichever is the [higher/lower].

25 26. Now look at the lists of these


lower inventories on the balance sheet in Panel
B. We know that these have been valued
at or current value,
whichever is the

26 27. In addition, the company has


cost allowed for the fact that some of its
market stocks may be spoiled (or obsolete). To
lower allow for such stock losses the company
has the value of these inventories
by 1,100.

27 28. In other words, the company has


reduced apparently been e in valuing its
stocks.

30
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

28 VALUATION OF CURRENT ASSETS


cautious 29. Let us pause for a moment to
summarise what we have been saying in
the last two sections, remembering that
assets + inventories = current

29 30. One thing we can sometimes see


quick from a balance sheet is whether or not
assets the management has been cautious in
the current assets.

30 31. Customers' accounts and similar


valuing accounts usually show the amounts
actually to the enterprise. An
amount is sometimes [added/subtractedj
to allow for estimated non-payment of a
certain number of

3I 32. Quick assets in the form of cash


owed may have to be adjusted in value if the
subtracted cash is held in a currency.
accounts

32 33. The market value of marketable


foreign securities may fluctuate widely. These are
therefore usually shown on a balance
. sheet at

33 34. At the same time balance sheets


cost should always indicate the
of marketable securities.

34 35. Stocks of finished products, raw


market value materials, etc., are usually valued at
or current market
whichever

3!
How to read a balance sheet

CHECK FRAME YOUR ANSWER

35 VALUATION OF FIXED ASSETS


cost 36. Fixed assets are valued on a
value different basis from current assets. Fixed
is the lower assets, remember, include assets in-
tended for relatively -term use in
the business.

36 37. Most of the fixed assets, such


long as buildings, plant, machinery and
manufacturing tools, will gradually be
worn out as they are used. In other words
most of the fixed assets will depreciate,
or [increase/decrease] in value.

37 38. Generally, fixed assets are shown


decrease on a balance sheet at their original cost
with an amount subtracted to allow for
the fact that their value has decreased, or
depreciated. This allowance is known as
d___

38 39. Look at the balance sheet in, Panel


depreciation B. By 3 I December 1983 the value of the
fixed assets had been reduced by
(how much?). other words 4,600 is
the amount of accumulated at
31 December 1983.

39 40. Most of the fixed assets, then,


4,600 are normally valued at less
depreciation .

The value shown on the balance sheet


for land, however, normally remains at
cost. Usually no increase or decrease in
the value of the land is recorded on the .

balance sheet unless the land is actually


sold or revalued.

32
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

40 41. Tosumup:forthepurposeofthe
cost balance sheet, land is generally valued at
depreciation .The other fixed assets are
valued at

41 42. Depreciation reduces the original


cost cost of fixed assets by a certain amount
cost less each year over the working life of the
depreciation asset; that amount is charged as an
expense in the profit and loss account.
The amount of depreciation charged in
any one year will therefore affect the
overall profit before income tax; it will
thus affect the amount of tax to be paid
by a company. The taxation laws of many
countries therefore control the rate at
which fixed assets can be

42 43. The at which fixed assets


depreciated can be depreciated is often controlled by
law. Now look once again at the assets on
the balance sheet in Panel B. Below the
allowance for depreciation there is an
entry called

43 44. Goodwill is an "intangible" asset


rate and there is nothing concrete to show for
goodwill it. Goodwill means the advantage, or
• benefit, that comes from the enterprise's
reputation, from its good relations with
customers, and so on.
Because goodwill is intangible it is
[easy/difficulty to value.

44 45. Goodwill is an example of an


difficult asset. Such assets are difficult to

33
How to read a balance sheet

CHECK FRAME YOUR ANSWER

45 46. Intangible assets are normally in-


intangible cluded on a balance sheet only when they
value have been purchased. If an enterprise is
bought as a going concern (active
business), the price paid may include a
certain amount for the goodwill, and this
would then be shown on the balance
sheet.
Goodwill that has not been bought
from someone else will normally
[appear/not appear] on the balance
sheet.

46 47. We can assume that the goodwill


not appear shown on the balance sheet in Pane! B has
been by our company.
Intangible assets may be shown
separately or as part of the
assets.

47 48. When intangible assets are first


bought purchased, they are shown on the
fixed balance sheet at cost. When the law
permits, like most other fixed assets they
are subsequently

48 49. To sum up, assets such as


depreciated goodwill may be shown separately or as
part of the [fixed/current] assets. Such
assets can be given a money value only
when they are from someone
else.

49 50. When intangible assets are bought,


intangible they are normally shown on the balance
fixed sheet at Afterwards they may
bought be
But now, is a really fast car a quick
asset?

34
The investment side of the balance sheet — assets

CHECK FRAME YOUR ANSWER

50 That brings us to the end of Chapter 2.


cost Make a note of how long it took you to
depreciated complete Set 4 and of the number of
No! frames in which you made a mistake, and
fill in the Progress Work Sheet. Then
reread the summary at the beginning of
this set before trying the following
questions which will test your knowledge
of the two sets in this chapter.

35
______________ _______

The investment side of the balance sheet — assets

MINI-TEST ON CHAPTER 2
Now it is time to see how much you have learned. Answer the questions
below and, when you have finished, check your answers on the following
pages. Then enter the number you answered correctly on the Progress
Work Sheet.

I A balance sheet shows the position of an enterprise [at a particular


date/over a period of years).

2 A balance sheet always shows two main groups of figures, the assets
and the liabilities. The show what money has been made
available to the enterprise from different sources; the show
how this money has been employed.

3 In simple words, assets are what is o by an enterprise.

4 assets are acquired for long-term use in the business.


Current assets include assets that are likely to be
during the operating cycle of the business.

5 The operating cycle of most manufacturing companies is usually


[more/less] than one year.

6 Fixed assets [are/are not] likely to be converted into cash in the


normal course of events.

7 assets represent the enterprise's short-term employment of


its funds; assets represent the long-term employment of
funds. assets are likely to remain constant in quantity from
day to day.

8 Fixed assets often include (give three items).

9 Stocks of raw materials, finished products and other supplies are


assets.

10 Below is a mixed list of assets. Put a C beside each of the current


assets and an F beside each of the fixed assets.
finished products land machinery
customers' accounts cash in banks buildings
raw materials marketable securities

37
How to read a balance sheet

Answers to mini-test on Chapter 2

I at a particular date.

2 liabilities; assets.

3 owned.

4 Fixed; converted into cash.

5 less.

6 are not.

7 Current; fixed; Fixed.

8 land, buildings, plant and machinery, motor vehicles, or fixtures and


fittings (any three).

9 current.

10 C finished products F land F machinery


C customers' accounts C cash in banks F buildings
C raw materials C marketable
securities

38
_______
_______
_______ _______
_______
_______
_______. _______
_______

The investment side of the balance sheet — assets

Mini-test (cont.)

Quick assets are part of the assets. They include cash and
assets which can normally be

12 Inventories, or stocks of raw materials, finished products and other


supplies [are/are not] usually regarded as part of the quick assets.

13 A balance sheet will usually show whether or not the management has
been in valuing the assets of the company.

14 Stocks of finished goods and other supplies are normally valued at

I5 Marketable securities are normally shown on a balance sheet at


but the balance sheet should always indicate

16 Assets in the form of foreign currency are [never/sometimes]


adjusted in value on a balance sheet.

17 Manufacturing tools, plant and buildings are assets. They


normally [increase/decrease] in value. Manufacturing tools, plant and
buildings are normally valued at

18 Land is usually valued at

19 Intangible assets such as goodwill may be shown separately or as part


of the assets. Usually they appear on a balance sheet only
when they have been When they are first acquired,
intangible assets are shown on a balance sheet at
Afterwards, they may be

20 The rate at which fixed assets can be depreciated for purposes of


taxation is usually controlled by

39
How to read a balance sheet

Answers (cont.)

I current; quickly converted into cash.

12 are not.

13 cautious.

14 cost or current market value, whichever is the lower.

IS cost; market value.

I 6 sometimes.

17 fixed; decrease; cost less depreciation.

I8 cost.

19 fixed; bought; cost; depreciated.

20 law.

How did you do?

More than I 5 You are doing very well. Go on to Chapter 3.


correct?
10- 15 correct? You are making good progress, but read through
the summaries of Sets 3 and 4 again, just to
consolidate your knowledge before going on to
Chapter 3.
Fewer than 10 It might be a good idea to go back and work
correct? through Chapter 2 again.

40
THE FUNDING SIDE OF THE 3
BALANCE SHEET — LIABILITIES
3. SET 5. CURRENT LIABILITIES AND FIXED
LIABILITIES
Estimated time: 20 minutes

Summary

A company's liabilities are usually listed on a balance sheet in three main


groups: current liabilities; fixed liabilities; and shareholders' funds (or
owners' equity).

The shareholders are the owners of the company. On the balance sheet
the funds they provide are shown separately from those of "outsiders"
who have loaned money to the company.

Current and fixed liabilities are together referred to as "outside


liabilities".

Fixed liabilities represent the company's long-term finance, and include


items on which interest is payable, such as long-term loans from
development banks and mortgage loans.

Current liabilities represent the company's short-term finance, and


include items like bank short-term loans, bank overdrafts and trade
accounts payable.

Interest always has to be paid on bank loans, but most other current
liabilities do not require the payment of interest. Apart from bank
financing, then, current liabilities generally represent low-cost finance for
the company (unless cash discounts are lost).

41
How to read a balance sheet

IMPORTANT NOTE

The balance sheet records actual liabilities not financial


commitments. Thus, if a company has entered a contract for
purchases over ten years this financial fact will not appear on the
balance sheet. However, the commitment should be revealed in the
notes to the financial statements.

42
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

Is your answer I. A balance sheet is a statement of the


right? Check below, assets and of an enterprise at a
particular

I 2. We have just looked at some typical


liabilities assets, and in this chapter we shall be
point in time (or dealing with liabilities.
date) In simple terms, the liabilities of an
enterprise are what it

2 3. If an enterprise is to function, it must


owes have finance so that it can buy land,
buildings and other assets; and
so that it can acquire raw materials and
other assets.

3 4. It is possible to tell how an enterprise


fixed has obtained its finance by looking at the
current on its balance sheet.

4 5. On the other hand, the on


liabilities the balance sheet show how the company
has employed this finance.

5 6. Here are the main headings you


assets might find on a balance sheet:

ASSETS LIABILITIES
Current assets Current liabilities
Fixed assets Fixed liabilities
Shareholders'
funds
Total Total

Whereas there are two main groups of


assets, there are usually main
groups of liabilities shown on a balance
sheet.

43
How to read a balance sheet

CHECK FRAME YOUR ANSWER

6 Now open out Panel C (page 48) which


three gives another balance sheet, showing
some of the liabilities in more detail.
7. On the balance sheet in Panel C,
the liabilities are grouped into
liabilities, liabilities, and

7 8. The shareholders are the owners of


current the company. The money they have put
fixed into the company (the shareholders'
shareholders' funds funds or owners' equity) is money the
company owes to the shareholders. The
shareholders' funds are thus part of the
total of the company.

8 9. The other liabilities of the company


liabilities are described as "outside" liabilities.
These consist of the current and
the liabilities.

9 10. The total liabilities of the company


liabilities thus consist of the shareholders' funds
fixed plus the liabilities. The outside
liabilities consist of the
and the

10 OUTSIDE LIABILITIES
outside II. Now look at the outside liabilities
current liabilities (the current and fixed liabilities) on the
fixed liabilities balance sheet in, Panel C. Both groups of
liabilities include amounts of money owed
to banks and other people. One group
does not have to be paid for a relatively
long time, while the other group may
have to be paid fairly quickly.
Which group of outside liabilities
would you say were the long-term
liabilities: current liabilities or fixed
liabilities?

44
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

I 12. Current liabilities usually have to be


fixed liabilities met, or paid, in the [long/short] term.

12 3. liabilities usually have to be


short met within one year.

13 14. Bank overdrafts are part of the


Current current liabilities. Overdrafts, then, are
[short-term/long-term] advances from
banks.

4 15. Accounts with trade creditors


short-term (trade accounts payable) and other
creditors usually have to be paid [fairly
quickly/in the long term]. They are part
ofthe

5 16. Look at the list of current liabilities.


fairly quickly It includes bank trade,

current liabilities and provision for

16 17. Bank overdrafts and other current


overdraft liabilitiesrepresent the enterprise's
accounts payable [long-term/short-term] finance.
taxation

17 8. Is it true to say that current


short-term liabilities may have to be met within a
relatively short period?

18 19. Current liabilities are usually met


Yes from the short-term, or [current/fixed],
assets.

19 . 20. This means that an enterprise


current should generally have enough .

to cover the current liabilities.

45
How to read a balance sheet

CHECK FRAME YOUR ANSWER

20 21. Look at the first few current


current assets liabilities in Panel C. Most of them do not
involve the payment of interest. Which
item in the current liabilities always in-
volves the company in paying interest?

21 22. Interest sometimes has to be paid


Bank overdraft on trade accounts if they are not met
within a certain time. However, the only
current liability which always involves the
payment of interest is

22 23. Apart from bank overdrafts, then,


bank overdraft the current liabilities generally represent
[low-cost/expensive] finance for the
company.

23 24. As a general rule, an enterprise


low-cost will try to obtain the use of as much
finance as possible.

24 25. Long-term liabilities are known as


low liabilities.

25 26. The fixed liabilities represent the


fixed company's -term finance.

26 27. Fixed liabilities may include items


long like long-term loans from development
banks and loans.

27 28. To obtain long-term loans, an


mortgage enterprise usually has to offer some of its
property as security. This means that if
the enterprise cannot repay the loan
when it is due then the may be
sold to repay the loan.

46
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

28 29. On the balance sheet in PaneiC the


property money raised by mortgage loan amounts
to The security for this
mortgage is real estate (land and
buildings) belonging to the company: in
other words, the security is part of the
assets.

29 30. Very often companies cannot get


8,000 long-term loans unless they have
fixed assets to offer as security.
Our balance sheet illustrates a special
case where a company has a long-term
loan from a development bank; this loan
is secured on the total

30 31. Fixed liabilities represent the


long company's -term finance, while
assets current liabilities represent its
finance,

31 32. Fixed liabilities represent money


long which has been borrowed for a long
short-term period; the company [has to pay/does
not have to pays compensation in the
form of interest.

32 33. Look at the balance sheet in Pane! C.


has to pay The annual interest on the devel-
opment bank loan is per cent
of 50,000 and the annual interest on the
mortgage loan is per cent of

33 34. The total interest to be paid by the


0 company on its fixed liabilities each year is
9 therefore:
8,000 + =
(The balance sheet shows that 890 of this
is still unpaid!)

.47
How to read a balance sheet

CHECK FRAME YOUR ANSWER

34 35. In developed countries the interest


5,000 rates on long-term loans are relatively
720 low. In developing countries, on the other
5,720 hand, they tend to be

35 36. Where there are not sufficient


higher fixed to offer as security, the
interest to be paid on long-term loans, or
liabilities, is usually [low/high].

36 37. What is the total of our company's


assets short-term finance at 3 I December
fixed • 1983?
high

37 38. What is the total of the long-term


178,860 finance at this date?

38 39. Are shareholders' funds (owners'


58,000 equity) actually repaid to the owners
each year?

39 You have now reached the end of Set 5.


No Once again make a note of the time taken
and the number of frames in which you
made an error. Then reread the summary
at the beginning of this set before going to
Set 6. Remember, the glossary is available
to help you with any difficult word.

48
_______

PANEL C

HOUSEHOLD UTENSILS LTD.


Balance sheet at 3! December 1983 (expressed in WCU)

ASSETS LIABILITIES

Current assets 335 400 Current liabilities


Bank overdraft 84160
Trade accounts payable 81 000
Other accounts payable 8 000
Provision for taxation 2 8 10
Provision for unbilled expenses 2 000
Interest due on fixed liabilities
(still unpaid) 890
178 860
Fixed assets 21 200 Fixed liabilities
Development bank loan at 10 per cent
interest, repayable 2001 (secured on
all current and fixed assets) 50 000
Mortgage loan at 9 per cent repayable
1995 (secured on the real estate) 8 000
58 000
Total outside liabilities 236 860

Shareholders' funds 119 740

Total assets 356 600 Total liabilities 356 600

PANEL D — overleaf
PANEL D

- HOUSEHOLD UTENSILS LTD.


Balance sheet at 3! December 1983 (expressed in WCU)

ASSETS LIABILITIES

Current assets 335 400 Current liabilities 178 860


Fixed liabilities 58 000
Fixed assets 2l 200 Shareholders' funds
Capital issued:
10000 ordinary shares
of 10 money units each 100000
Capital surplus 8 440
Earned surplus I I 300
_______ 119 740
Total assets 356 600 Total liabilities 356 600
The funding side of the balance sheet — liabilities

3. SET 6. SHAREHOLDERS' FUNDS


Estimated time: 15 minutes

Summary

When a company is formed, it needs money to carry on its activities; a


good deal of this money usually comes from the shareholders, who buy
shares in the company.

The money which the shareholders put into the company in this way is
described on the balance sheet as the capital issued.

In return, at the discretion of the directors, the company makes payments


to shareholders (pays dividends) out of the profits made by the
company.

In addition to the capital issued, shareholders' funds also include capital


surplus and earned surplus, which represent profits retained in the
business and not paid to shareholders. (Capital surplus and earned
surplus will be considered in more detail in the next set.)

49
How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. In the last set we looked at current


right? Check below, and fixed liabilities. The third group
making up a company's total liabilities is
called

I Panel D gives another form of the balance


shareholders' funds sheet on Panel C which we discussed in
the previous set. The balance sheet on
Panel 0 shows the shareholders' funds of
our company as at 31 December 1983 in
more detail. Open out Panel 0 (page 49)
before continuing.
2. The biggest item in the shareholders' .

funds in December 1983 is the

2 3. When a company is formed it needs


capital issued money so that it can start up its business.
A good deal of this money generally
comes from the shareholders, who buy
in the company.

3 4. The money made available in this


shares way by the shareholders is described on a
balance sheet as the capital . .

4 5. Buying shares in a company involves


issued investing (or lending money) for the life
of the

5 .6. The capital issued can therefore


company be regarded as [short-term/permanent]
finance.
We will see later that in return for
investing this money the shareholders
will expect payments (dividends) from
profits made by the company.

50
The funding side of the balance sheet — liabilities

CHECK FRAME YOU R ANSWER

6 7. But first look at the other items in the


permanent shareholders' funds. As well as the capital
issued, the shareholders' funds of our
company include capital and
surplus.

7 8. In simple terms, capital surplus and


surplus earned surplus represent profits that
earned have been retained in the company and
not paid to

8 9. In other words surplus and


.

shareholders surplus are profits that have been


in the business.

110. Earned surplus is profit made in


capital the course of the company's normal
earned operations, whereas is
retained (or kept) profit that is not made from the normal
. operations. .

We will see later in the programme


that it may result from the sale of fixed
assets, among other things.

0 II. As the shareholders are the owners


capital surplus of the business, any profits retained in the
business, together with the capital issued,
are in theory owed to the

I I Ii. Capital issued and profits retained


shareholders in the business therefore appear on our
balance sheet as [assets/liabilities] and
together they make up the
funds.

51
How to read a balance sheet

CHECK FRAME YOUR ANSWER

12 13. Although the shareholders' funds


liabilities are shown as being owed to the
shareholders' shareholders, they will never be com-
pletely paid to the shareholders until the
company is wound up. The shareholders'
funds can therefore be regarded as
p finance.

13 14. To sum up so far, the company's


permanent permanent finance is shown on our
balance sheet under the heading

14 15. The main items in the shareholders'


shareholders' funds funds are likely to be
and surplus.

IS CAPITAL ISSUED AND DIVIDENDS TO


capital issued SHAREHOLDERS
capital surplus 16. We have seen that the capital
earned surplus and earned surplus figures on a
balance sheet represent that
have been in the company.

16 17. In other words, capital surplus and


profits earned surplus represent profits that
retained (or kept) [have/have not] been paid to share-
holders in the form of dividends.

17 Before we go on in the next set to


have not consider the difference between capital
surplus and earned surplus, let us look
briefly at what is meant by shareholders'
dividends.
18. We know that a company always
has to pay interest on its fixed liabilities,
or loans.

52
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

8 19. We also know that capital issued


long represents the money invested by the

9 20. A company does not have to pay


shareholders interest (as such) on the capital issued,
but some compensation will be expected
by the

20 21. Where there are sufficient profits


shareholders the shareholders will naturally expect
compensation for the money they have
made available to the company, in the
form of dividends.
The shareholders are compensated by
payments known as

21 22. Now, all shareholders have rights:


dividends for example, the right to share in the
made by the company.
There may, however, be different
classes of shares which carry with them
rights.

22 23. However, we are concerned here


profits with the basic class of shares, often
different known as ordinary shares. Look at the
(For example, balance sheet in Panel 0. To find out what
a company may shares (or capital) have been issued
issue preference by the company you have to look at
shares, which give a the group of liabilities called [fixed
preferential right liabilities/shareholders' funds]. •

to dividends.)

23 24. Our company, Household Utensils


shareholders' funds Ltd., has issued 10,000 shares.

53
How to read a balance sheet

CHECK FRAME YOUR ANSWER

24 Now fold away Pane! 0.


ordinary .25.,The ordinary shareholders (those
who hold ordinary shares) are the basic
owners of the company; if the company
were to fail, the ordinary shareholders
would run the risk of I_______ some or all
of their money.

25 26. Note also that the claims of all


losing creditors and other investors have
priority over the claims of the ordinary
shareholders; if the company failed, the
ordinary shareholders' claims on any
funds remaining in the company would be
the [first/last] to be met.

26 27. The ordinary shareholders, then,


last run [less/more] risk of losing.their money
than people who give long-term secured
loans.

27 28. The ordinary shareholders will


more therefore generally expect to get a
[bigger/smaller] return on their money -

than the interest paid on long-term


loans.

28 29. However, although the ordinary


bigger shareholders have a general right to share
in the profits of the company, they do not
. have the right to a fixed each
year.

29 30. Dividends to shareholders can only


dividend (or be paid out of profits. Thus the amount of
payment) any dividend will depend to a certain
extent on the size of the made by
the

54
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

30 31. The directors of the company


profits normally recommend each year the
company amount of_______ that should be paid to
the ordinary shareholders.

31 32. When they are considering what


dividend profits are available and how much
dividend (if any) should be paid, the
directors have to take into account a
number of factors. One of these is the
needs of the itself.

32 33. If there are plans for expanding the


company company, for example, profits may need
to be in the company to finance
them.

33 34. In recommending what amount of


retained (or kept) dividend is to be paid, the directors also
bear in mind the fact that many people
prefer to have a fairly steady annual
income. The profits made by the
company may vary considerably from
year to year. Is the dividend paid to the
ordinary shareholders likely to vary to
the same extent?

34 35. Do you think that:


No (a) shareholders always prefer high
dividends? or that
(b) shareholders may prefer lower
dividends and an increased market
value of their shares?

35 And that brings us to the end of another


(b) (Remember that set. As usual, make a note of the time
shareholders are taken and the number of frames in which
people; they may you made a mistake. Then reread the
want different things summary at the beginning of this set
at different times.) before going on to Set 7.

55
How to read a balance sheet

3. SET 7. CAPITAL SURPLUS AND EARNED SURPLUS;


CAPITAL AUTHORISED AND CAPITAL ISSUED
Estimated time: 5 minutes

Summary

Profits made in the course of the normal operations of an enterprise, and


retained in the business, are called earned surplus.

Increased value from the revaluation of fixed assets is called capital


surplus.

The amounts on the balance sheet for earned surplus and capital surplus
do not reflect the amounts made during the year. Rather, they are the
cumulative totals for several years up to the date of the balance sheet.

Every properly constituted company is legally able to issue a certain


amount of share capital. This is known as its capital authorised.

However, a company may not need all the share capital it is authorised to
issue, and the company invites shareholders to contribute only as much
money as it actually needs. The amount actually contributed by the
shareholders is called the capital issued. It is always either less than or
equal to the capital authorised.

IMPORTANT NOTE

The "liability" of a company for shareholders' funds is not a legal


liability but it is a useful way to start to learn about balance sheets. In
practice, the "liability" is not payable to the owners of a company
unless the company is wound up.

Thus, it is more correct to say that the balance sheet shows the
assets of a company and how the assets are financed from liabilities
and from shareholders' funds.

56
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

Is your answer I. In the last set we saw that some of the


right? Check below, profits made by a company over the years
will be paid to shareholders in the form of
dividends, and that some will be
in the company.

I 2. Capital surplus and earned surplus


retained (or kept) represent profits that [have/have noti
been paid to shareholders. They are
profits held in the business and they form
part of the

2 3. We will see that, if a company makes


have not a profit during any one year, the amount
shareholders' funds of shareholders' funds is likely to
increase. On the other hand, if the
company makes a I , the amount

of these funds will decrease.

3 4. Thus the shareholders' funds shown


loss on the balance sheet are likely to
if the company makes a profit during the
coming financial year; they will if
the company makes a .

4 5. Now look at the balance sheet in


increase Panel 0 once more. At the end of 1983
decrease how much earned surplus was there?
loss .

5 6. The earned surplus shown on the


11,300 balance sheet for 3 I December 1983
represents:
(a) profits made during 1983;
(b) accumulated profits less dividends
for several years to 31 December
1983.

57
How to read a balance sheet

CHECK FRAME YOUR ANSWER

6 7. Earned surplus is part of the profit


(b) (The balance made by the company as the result of
sheet is not a its normal operations. The normal busi-
statement of results ness of our company is manufacturing
for a particular household goods. Suppose the company
year: it gives revalued some of its land: would this
accumulated totals increased value be included in the earned
at a particular point surplus shown on the balance sheet?
in time.)

7 8., Value arising from the revaluation of


(The company's fixed assets, then, would generally appear
normal business is on the balance sheet under the item
manufacturing, not called
selling land.)

8 9. If during a particular year the


capital surplus company made a loss in the course of its
normal operations, then any
shown on the balance sheet
would be reduced. If the balance sheet
showed no earned surplus, then any loss
made in the course of normal opera-
tions would be deducted from capital
surplus.

9 10. In other words, profits made by an


earned surplus enterprise are likely to i the
shareholders' funds; losses will

0 I I. We saw earlier that dividends are


increase paid to shareholders out of profits made
decrease by the company; to be more exact, they
are paid out of the profits made by the
company in the course of its normal
operations.
In other words, dividends are not paid
out of surplus.

58
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

II 12. The profit, or surplus, made in the


capital course of normal operations in any one
year is often known as the company's net
. profit.
Net profit is the p remaining
I

after all expenses have been deducted


from income.

2 13. Suppose our company makes a net


profit profit from its normal operations in any
one year. Let us see what happens to
. this.
First, all profits are taxed. Some of the
net , then, will have to be put
aside to pay the profits

13 14. Of the net profit remaining after


profit tax, some may be paid to shareholders in
tax the form of

14 IS. However, as we have seen,


dividends companies normally need to retain some
I of their profits in the business. There may
be future plans requiring finance (or
profits may already have been used to
finance expansion which has taken
place).
It is therefore unlikely that all the net
profit remaining after allowing for tax will
be paid to will be
in the business.

15 16. In any year, then, if a company


shareholders makes a net profit from its normal
retained operations: some will be put aside to pay
profits some may be paid to
intheformof ;andsome
will probab'y be

59
How to read a balance sheet

CHECK FRAME YOUR ANSWER

16 Il. Net profit, remember, is profit


tax made during the year in the course of the
shareholders company's
dividends
retained in the
business

17 18. Any net profit that is retained in the


normal operations business increases the amount of
surplus shown on the balance sheet.

18 19. Suppose that the company makes a


earned loss in the course of a year's normal
operations. It may still be able to pay
dividends out of accumulated
from previous years.

19 20. The surplus is always


earned surplus available for paying dividends. Dividends
are not paid out of the surplus.

20
earned
capital
HOUSEHOLD UTENSILS LTD.
Balance sheet at 31 December 1983
(expressed in WCU)
ASSETS LIABILITIES
Current assets 335400 Current liabilities 178 860
Fixed assets 21 200 Fixed liabilities 58000
Shareholders' funds:
Capital authorised 200 000
Capital issued:
10 000 ordinary shares
of 10 money units each 100000
Capital surplus 8 440
Earned surplus II 300
Total shareholders' funds 119 740
Total assets 356 600 Total liabilities 356600

60
The funding side of the balance sheet — liabilities

CHECK FRAME YOUR ANSWER

CAPITAL ISSUED AND


CAPITAL AUTHOR!SED
21. We knew previously how much
capital the company had issued: how
much had been subscribed by
This amount is

21 22. The balance sheet opposite now


shareholders shows how much capital the company is
100000 legally to issue.

22 23. Household Utensils Ltd. is legally


authorised authorised to issue a total of
money units of capital. If the company
needs more finance in the future it
can therefore invite shareholders to
subscribe (how many?) more
money units of capital.

23 24. Which of the following is added


200,000 into the total of the shareholders' funds:
00,000 (200,000 [capital authorised/capital issued! both
minus 100,000) capital authorised and capital issued]?

24 25. The amount of capital that a


capital issued company is legally permitted to issue is
usually known as the

25 26. Companies do not always invite


capital authorised subscription for all the capital which they
are legally authorised to issue. One
reason is that the company may not
be able to employ all this money
profitably.
Shareholders, however, will expect
compensation for the money which they
subscribe, whether it is employed
or not.

.61
How to read a balance sheet

CHECK FRAME YOUR ANSWER

26 27. Thus, it is obviously unwise for a


profitably company to have surplus money that
cannot be

27 28., In the next chapter we will look at


employed (or used) the balance sheet as a whole. But before
profitably we finish with the liabilities, there is an
important point to note.
Suppose our company had made a
contract with a which committed
it to making certain purchases for the
next ten years. Would you learn this
from examining the liabilities on the
current balance sheet? Would
the purchase commitment be revealed in
the notes to the financial statements?

28 29. Financial obligations of this kind


No may not appear on the balance sheet but
Yes will appear in the
The balance sheet would include, under
liabilities, only the amount due at the
i of the balance sheet.

29 30. Balance sheets, then, do include


notes to the all of an enterprise's i
for the
financial statements future. Incidentally, if you sold that fast
date car at a profit, would it increase earned
surplus or capital surplus?

30 You have now reached the end of


obligations Chapter 3. Once again make a note on
Earned surplus, (It the Progress Work Sheet of the time you
would be part of the took and the number of frames in which
non-operating you made a mistake before going back to
income for the read the summary of Set 7 once more.
year.) Then do the mini-test on Chapter 3 to see
how much you have remembered.

62
___________
_______
________ ________ ______________
_______

The funding side of the balance sheet — liabilities

MINI-TEST ON CHAPTER 3
Now, see if you can complete this test on the material in Chapter 3. The
answers are on the following pages but do not look at them until you have
finished the test.

I It is usually possible to see how an enterprise has obtained its finance


by looking at the [assets/liabilities] on its balance sheet.

2 The three main groups of liabilities are usually called


and

3 The outside liabilities consist of the

4 (a) The represent the permanent finance.


(b) The represent the short-term finance.
(c) The represent the long-term finance.

5 Bank overdrafts are [short-term/long-term] advances from banks.


They are classed as liabilities.

6 As a rule, an enterprise should be in a position where it can meet its


current liabilities from its

7 Capital surplus and surplus are part of the

8 Fixed liabilities are usually -term loans.

9 To obtain long-term loans, an enterprise usually has to offer some of


its assets as security. As a rule, long-term loans will not be obtainable
unless the enterprise has sufficient [current assets/fixed assets] to
offer as security.

IC Below is a mixed list of liabilities. Put a C beside the current liabilities,


an F beside the fixed liabilities, and an S beside the shareholders'
funds.
earned surplus mortgage loan
bank overdraft capital issued
trade creditors capital surplus

63
How to read a balance sheet

Answers to mini-test on Chapter 3

I liabilities.

2 current liabilities; fixed liabilities; shareholders' funds.

3 current liabilities and the fixed liabilities.

4 (a) shareholders' funds;


(b) current liabilities;
(c) fixed liabilities.

5 short-term; current.

•6 current assets.

7 earned; shareholders' funds.

long.

9 fixed assets.

10 S earned surplus F mortgage loan


C bank overdraft S capital issued
C trade creditors S capital surplus

64
_______ _______
_______ _______

The funding side of the balance sheet — liabilities

Mini-test (cont.)

Interest [has to be paid/does not have to be paid] on bank


overdrafts.

12 Where an enterprise does not have sufficient assets to offer as


security for long-term loans, the interest charged on these loans is
likely to be

13 Apart from bank overdrafts, current liabilities represent


[low-cost/expensive] finance for the company.

14 Banks, ordinary shareholders and other creditors all lend money to


companies. Which group runs the greatest risk of osing its
money?

IS A balance sheet should show not only how much capital has been
issued by a company, but also how much capital the company is
to issue.

16 Capital surplus represents accumulated profit that [has/has not] been


made in the course of an enterprise's normal operations.

17 Is the following statement correct or incorrect? All the net profit


made by a company as a result of its normal operations is distributed
to the shareholders in the form of dividends.

18 Earned surplus is part of the profit made in the course of


Earned surplus represents net profit that has been
[distributed to shareholders/retained in the business].

19 If a company makes a loss as a result of its operations in any one year,


this will reduce the [current liabilities/fixed liabilities/shareholders'
funds] on the balance sheet.

20 When recommending the amount of dividend, the directors must


also take into account the financial needs of the

65
How to read a balance sheet

Answers (cont.)

.11 has to be paid.

12 high.

13 low-cost.

14 ordinary shareholders.

I5 authorised.

i6 has not.

17 Incorrect.

I 8 normal operations; retained in the business.

19 shareholders' funds.

20 company or enterprise.

How did you do? .

More than 15 You are doing very well. Go on to Chapter 4.


correct?
10- 15 correct? You are making good progress, but why not read
through the summaries of Sets 5, 6 and 7 again
before going on to Chapter 4?
Fewer than 10 It might be a good idea to work through this
correct? chapter again. Remember to write down all your
answers I

66
THE OVERALL .4
BALANCE SHEET
4. SET 8. FINANCIAL STRUCTURE
Estimated time: 30 minutes

Summary

To understand the financial structure of a company, it is important to


know the way in which the assets (current and fixed) are financed by the
shareholders' funds and the outside liabilities.

By comparing the balance sheet figures for various groups of assets and
liabilities we can determine whether or not the company is 'solvent" and
"liquid".

The enterprise is solvent if assets are greater than outside liabilities. It is


liquid if it can meet its current liabilities out of current assets. Current
assets less current liabilities is known as net working capital.

Gearing refers to the ratio of shareholders' funds to borrowed money


(loan capital). Gearing of 4 : is low because four-fifths (80 per cent) of
I

the assets are financed by shareholders' funds and only one-fifth (20 per
cent) by borrowed money. By contrast a ratio of : 4 is high gearing
I

(high borrowing).

Always compare the current balance sheet figures with the previous
balance sheet to determine material (significant) changes and ask why
such changes have occurred.

Most published balance sheets give two sets of figures (for the current
year and for the previous year) to show how the current financial position
of the company compares with its previous financial position. A sources
and uses of funds statement based on such a comparison is also provided.
(The sources and uses of funds statement will be discussed in Set 9.)

IMPORTANT NOTE

For the financial management of a business, cash is more important


than profit!

67
______________'. _______________________

How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. First, open out Pane! E (page 92).


right? Check below. The balance sheet in Panel E is dated
but it also gives the
corresponding figures at

2.. By examining the balance sheet


3I December 1984 figures at two dates we can see whether
3I December 1983 the company's position has
between these dates.

2 THE COMPANY'S POSITION AT THE


changed (improved END OF 1983
or deteriorated) 3. Before looking at changes, however,
let us look at the company's position at
the end of 1983, as shown by this balance
sheet. The first thing to do is to check that
the company is in a position to meet its
outside liabilities.
The outside liabilities are the
and the

3 Now leave Panel E for a moment.


current liabilities
fixed liabilities
SMITH MANUFACTURES LTD.
Balance sheet at 31 December 1983
(expressed in WCU)

ASSETS LIABILITIES
Quick assets 180 Current liabilities 180
Inventories 200 Fixed liabilities 200
Land,building,plant,etc. lOO Total outside liabilities 380
— Shareholders' funds 100

Total assets 480 Total liabilities 480

4. So far, we have been looking only at


balance sheets which show companies in a
position to meet their outside liabilities.
But here is another. Can this company
meet its outside liabilities out of its total
assets?

68
The overall balance sheet

CHECK FRAME YOUR ANSWER

4 5. Now suppose that shortly after this


Yes balance sheet was drawn up the company
lost most of its inventories (stocks of
finished goods, raw etc.) and its
,

fixed in an earthquake. (The


company had not insured against this.)
The company would have to reassess its
position and might draw up another
balance sheet as shown below.

5
materials
assets SMITH MANUFACTURES LTD.
Balance sheet at 20 January 1984
(expressed in WCU)

Dec. Jan. Dec. Jan.


1983 1984 1983 1984
ASSETS LIABILITIES
Quick assets 180 180 Current liabilities 180 180
Inventories 200 10 Fixed liabilities 200 200
Fixed assets 100 10 Total outside
liabilities 380 380
Shareholders'
funds 100

Total assets 480 200 Total liabilities 480 200

6. In January 1984 the value of the


assets has been greatly reduced, but the
outside liabilities still remain. The balance
sheet still balances (because the share-
holders' funds now show a negative
amount); let us see whether the company
can still meet its outside liabilities out of
its total assets.
The total assets in January 1984 are
(figures). The outside liabilities
at that date are (figures).

6 7. The corn pany, then , ca nnot meet its


200 out of its
:380

69
How to read a balance sheet

CHECK FRAME YOUR ANSWER

7 8. In this example the balance sheet


outside liabilities shows that the company was not solvent
total assets in january 1984. A company is said to be
solvent if it can meet its
put of its

8 Now let us return to Panel E (page 92)


outside liabilities and check to make sure that the company
total assets shown there was solvent at the end of
1983.
9. At 31 December 1983 the total
assets were (figures) and the
outside liabilities were (figures).

9 10. At the end of 1983, then, our


356,600 company was
236,860

10 II. An enterprise is said to be solvent if


solvent its are greater than its

I 12. Now, an enterprise will not have to


total assets meet all its outside liabilities in the short
outside liabilities term in other words, it will not have to
meet both the current and fixed liabilities
in the short term.
I
However, it may have to meet the
liabilities in the short term.

12 13. Any enterprise should therefore


current have enough [current assets/fixed assets]
to cover its current liabilities.

13 14. An enterprise is said to be liquid if it


current assets can meet its liabilities out of its
(Fixed assets are current assets.
not converted into
cash, as a rule.)

70
The overall balance sheet

CHECK FRAME YOUR ANSWER

14 IS. Remember that an enterprise is


current if it can meet its outside liabilities
out of its total assets; it is if it
can meet its current liabilities out of its
current assets.

15 .16. Now see whether our company


solvent was liquid at the end of 1983. To do this
liquid we must look at the and
the

16 17. The total current liabilities at


current liabilities 31 December 1983 were and
current assets the total current assets were

17 18. In other words, the current liab-


178,860 ilities [were/were not] covered by the
335,400 current assets. Therefore, the company
was at the end of 1983.

18 19. Now, working capital equals


were current assets minus current liabilities.
liquid At 3 I December 1983 our company had
. working capita' of 335,400 (current
.
assets) — (current liabilities) =
i

19 20. The greater the excess of current


178,860 assets over current liabilities, the
I56,540 [less/more] working capital the company
has.

20 21. In other words, a company has


more working capital as long as it is liquid. If a
company is not liquid it has no .

71
How to read a balance sheet

CHECK FRAME YOUR ANSWER

21 GEARING
working capital 22. Now let us compare the, share-
holders' funds at the end of 1983 with the
total finance employed by the company.
You can find the total finance employed
by an enterprise by looking at the figure
for the total assets or for the total
liabilities. Both these figures are the
since both sides of the •

sheet always balance.

22 23. Shareholders' funds at the end of


same 1983 were and the total finance
balance employed by the company at that date
was

23 24. Let us find what proportion of the


119,740 total finance employed by the company
356,600 the shareholders' funds represented.
Since:

l19,740x 100
= approx. 33 per cent,
356,600
at the end of 1983 the shareholders'
funds represented approximately one-
third of the total employed by
the company.

24 25. As we discussed in Chapter 3, all a


finance company's funds are borrowed either
from the shareholders (who the
company), or from persons outside the
company (the outside ).

25 26. In our present example, the dif-


own ference between the total finance and the
liabilities shareholders' funds (356,600 — 119,740
= ) represents the outside
liabilities (money borrowed from sources
other than the ).

72
The overall balance sheet

CHECK FRAME YOUR ANSWER

26 27. Now, the ratio of shareholders'


236,860 funds to borrowed money is known as the
shareholders gearing of a company. G_______ refers
to the ratio of shareholders' funds to
borrowed money.

27 28. Thus in our present example, the


Gearing ratio of 119,740 : 236,860 is the ratio of
shareholders' funds to borrowed money.
This ratio reflects the of the
company.

28 29. Rounding these numbers up to the


gearing nearest 10,000, we have the ratio of
120,000 : 240,000, or I : 2. The figures
on the balance sheet at Panel E thus
represent a g of

29 30. Note that the gearing is sometimes


gearing calculated as the ratio of shareholders'
2 funds to long-term loan capital only (the
fixed liabilities). In our calculations in
frames 26 to 29 above, the figure for
borrowed money includes both the
short-term loans (current ) and
the long-term loans (
liabilities).

30 CHANGES BETWEEN 1983 AND 1984


liabilities 31. Now let us see what changes have
fixed taken place between the end of 1983 and
the end of 1984.
First look at the total finance at the two
dates. In 1983 this was and in
1984 it is

31 32. In other words, the company had


356,600 [more/less] total finance in 1984.
286,980

73
How to read a balance sheet

CHECK FRAME YOUR ANSWER

32 33. The total liabilities have decreased


less by December 1984, and this decrease
is accompanied by a corresponding
decrease in the total

33 .34. We can see how this overall change


assets has come about. Look at the three main
groups of liabilities at the two dates.
Which group shows the biggest change
between December 1983 and December
1984?

34 35. The total current liabilities have


Current liabilities [increased/decreased] from to I

I (figures).

35 36. Now, the current liabilities show a


decreased particularly big change in one item;
178,860 the has been
82,974 [increased/reduced] from to

36 37. This means that the company has to


bank overdraft pay less on its bank overdraft.
reduced
84,160
10,520

37 .38. Now, if the current liabilities show a


interest big decrease we might expect to find a big
decrease also in the current

38 39. Let us look at the current assets


assets (Current at the two dates. The total has
liabilities are usually [increased/decreased] from
met from current (figure) in 1983 to (figure) in
assets.) 1984.

74
The overall balance sheet

CHECK FRAME YOUR ANSWER

39 40. This suggests that the company has


decreased used some of its to pay
335,400 off the liabilities.
267,000

40 41. The biggest single change in the


current assets current assets is that the
current have been reduced from (figure)
(figure).

41 42. The company also sold its


customers' accounts in 1984.
261,000
180,000

42 43. The current liabilities, then, show a


marketable big change between the two dates.
securities Look at the other two groups of
liabilities. Have the fixed liabilities
changed?

43 44. Look at the shareholders' funds.


No Between December 1983 and December
1984 the total has [decreased/increased]
from to

44 45. In other words, the shareholders'


increased holding in the company has increased.
II 9,740 We can see what has caused this change .

146,006 in the shareholders' funds.


For one thing, the company has issued
additional to the value of

Secondly, the earned surplus has


increased from to

75
How to read a balance sheet

CHECK FRAME YOUR ANSWER

45 46. To sum up the main changes on the


capital balance sheet between 31 December
20,000 1983 and 31 December 1984: the total
1,300 liabilities [increased/decreased] from
17,566 to ; the current liabilities
[increased/decreased] and in particular
the was reduced; the
current assets [increased/decreased]; the
main change here was in the
and also the shareholders' funds
[increased/decreased]; the main reason
for this was that more

46 47. As the total liabilities have de-


decreased creased, this means that the company is
356,600 employing less total at the end of
286,980 1984.
decreased
bank overdraft
decreased
customers' accounts
increased
capital was issued

47 48. We can see whether the pro-


finance (or money) portion of shareholders' funds in the total
finance has also changed.
In December 1984 the company's total
finance is 286,980. At this date the
shareholders' funds amount to

48 49. In other words, in 1984 the


146,006 shareholders' funds represent:
146,006x IOU
= approx. 50 per cent
286,980
of the

76
The overall balance sheet

CHECK FRAME YOUR ANSWER

49 50. Now look back to frame 24: at the


total finance end of 1983 the shareholders' funds
represented 33 per cent of the total

50 51.The proportion of shareholders'


finance money in the company at the end of
1984, then, is [greater/smaller] than at
the end of 1983.

51 52. Let us look at this change in terms


greater of changes in the gearing of the company.
Gearing is the ratio of______________ to
borrowed money.

52 53. At the end of 1984 borrowed


shareholders' funds money (total finance — shareholders'
funds) = 286,980 — =

53 54. At the end of 1984, therefore, it is


146,006 evident that the gearing of the company
I 40,974 is 146,006 ,which is very nearly

54 55. Fromtheendofl983totheendof
40,974 1984 the gearing has gone down from
l:2to

55 56. The higher the proportion of bor-


I rowed money to shareholders' funds, the
higher the gearing. If the gearing is : 4,
I

four-fifths (or per cent) of the


total finance comes from borrowed
money. This is a high proportion so we
say the is high.

77
How to read a balance sheet

CHECK FRAME YOUR ANSWER

56 57. lfthegearingis4 l,only


80 (or 20 per cent) of the total
gearing finance comes from
This is a low proportion, so we say the
gearing is
Gearing of about 2 : I, in which
(that is, approximately
33 per cent) of the total finance comes
from borrowed money is considered
normal.

57 THE COMPANY'S POSITION AT THE


one-fifth END OF 1984
borrowed money 58. Now that we have looked at the
ow main changes between the two dates, just
one-third check the company's general position at
the end of 1984.
We find that the total assets at 3 I
December 984 are (figures).
The total outside liabilities are: +
= Therefore, the
company is

58 59. An enterprise is said to be solvent


286,980 when its are covered by
82,974 its
58,000
140,974
solvent

59 .60. Now see whether the company is


outside liabilities still liquidat the end of 1984. An
total assets enterprise is said to be liquid when its
are covered by

60 61. In December 1984 our company's


current liabilities current liabilities are valued at
its current assets the current assets at

78
The overall balance sheet

CHECK FRAME YOUR ANSWER

6l 62. This means that the company is able


82,974 to meet its out of its
267,000 In other words, the
company is at the end of 1984.

62 63. Can the company also meet its


current liabilities current liabilities out of its quick assets in
current assets December I 984? At that date the quick
liquid assets are valued at:
L=

63 64. In other words, at 3 I December


450 1984 the company could, if necessary,
179,550 meet its out of its
180,000 .

64 In this set we introduced the idea


current liabilities of looking at changes in a company's
quick assets financial position from one balance sheet
to the next. We take this idea further in
the next set as we look at the sources and
uses of funds statement. Before going on
to that, however, note the time you took
to complete this set and the number of
frames in which you made a mistake
before reading through the summary for
this set once again.

79
How to read a balance sheet

4. SET 9. SOURCES AND USES OF FUNDS


Estimated time: 20 minutes

Summary

The sources and uses of funds statement is developed by comparing the


current balance sheet with that of the previous period and using some
other data.

The sources and uses of funds statement shows the changes that have
taken place in the period between the two balance sheets in terms of new
funds available to the business and how they have been used; it shows
where new money has come from (sources) and how it has been used
(uses).

Sources of new funds may be any of the following:


— net profit (after depreciation);
— depreciation;
— new share capital issued;
— sale of fixed assets;
— new loans.

Depreciation is not exactly a source of new funds but it reduces the net
profit for the period. Since no money for depreciation actually leaves the
business, the source of funds is net profit before depreciation, which is the
same as net profit after depreciation, plus depreciation.

The uses of funds may be any of the following:


— payment of dividends;
— purchase of fixed assets;
— repayment of loans or capital;
— increase in net working capital.

Sources of funds always equal uses. Any funds not used for the special
purposes above result in changes in net working capital (current assets
less current liabilities).

80
The overall balance sheet

IMPORTANT NOTE

The sources and uses of funds statement reveals the key financial
management decisions for the accounting period.

8!
How to read a balance sheet

cHECK FRAME YOUR ANSWER

Is your answer I. The total finance available to a


right? Check below, company usually does not remain the
same from year to year.
Common sense might suggest that the
more a company's total increases
from year to year, the better the
company is doing.

• 2. However, it is not quite as simple as


finance that. A company whose total finance has
increased from one year to the next may
not be in as healthy a position as one
whose has not
increased. It all depends on where the
money has come from and what it has
been spent on.

2 3. For example, a company whose total


total finance finances increased by 10,000 world
currency units (WCU) as a result of an
[increase/decrease] in earned surplus (or
"profits") is probably in a healthier
financial position than one which had no
in earned surplus but which
showed an increase of 20,000 WCU in its
total finance as a result of the issue of new
share

3 4. But again an increase in share capital


increase may or may not be a sign of financial
capital health. It all depends on what the money
is on.

4 5. On the one hand, the money may


spent be spent on modernising plant and
equipment so that a substantial in
profits may be expected in the future.

82
The overall balance sheet

CHECK FRAME YOUR ANSWER

5 6. On the other hand, the money might


increase be spent on the purchase of property for
the use of directors or top management,
which is less likely to lead to an increase in
for the company.

6 7. In other words, when new money


profits comes into a business, it is important in
assessing the company's financial position
to know where the money has come from
and what it has been on.

7 8. The sources and uses of funds


spent statement (sometimes called the funds
flow statement) is a document which is
often attached to the balance sheet, and
gives information about the sources and
of new money which has come .

into the company since the time of the


previous sheet.

8 9. In other words, the and uses


uses of funds statement is concerned with
balance ch_______ that have taken place in a
company's finances between one balance
sheet and the next.

9 10. The sources and uses of funds


sources statement is itself a sort of balance sheet.
changes On the one side is a summary of where
various amounts of money have come
from, and on the other, a summary of
what various amounts of money have
been spent on. The total of the sums of
money on the "sources" side must
the total of the sums of money
on the " " side.

83
How to read a balance sheet

•CHECK FRAME YOUR ANSWER

10 II. The and of funds


equal statement will show the changes that have
uses taken place in a company's finances in
respect of: share capital, long-term loans,
fixed assets and depreciation, net profit
and dividends, and working capital.

I I Ii. If new share capital has been issued


sources this will be reflected as a [source/use] of
uses funds.

12 13. On the other hand, if money has


source been returned to shareholders (in other
words, if some of the capital has been
repaid), this will be listed under the
of funds.

13 14. Similarly, if new long-term loans


uses have been taken out, this is a of
funds, whereas if long-term loans have
been repaid, this will be reflected under
the (Note that as short-
term loans are part of the current
liabilities, they are accounted for in the
of working capital. This will be
. discussed later in the set.)

14 15. Look at the balance sheet on Panel


source E once again and answer the following
uses of funds questions about changes in the finances
of Household Utensils Ltd. between
31 December 1983 and 3 I December
1984.
Share capital has increased by 20,000
units. On a sources and uses of funds
statement this would be listed as a
of funds.
Have any long-term loans been repaid,
or new ones raised?

84
The overall balance sheet•

CHECK FRAME YOUR ANSWER

IS 16. The purchase of fixed assets during


source a financial year will increase the value of
No the assets shown on the balance
sheet and the sale of fixed assets will
d_______ this value.

16 17. If the valuation of fixed assets on


fixed the balance sheet goes down from one
decrease year to the next, this means that more
money has come in from the of
fixed assets than was spent on the
purchase of new ones. This inflow of
money is new money coming into the
company, so any decrease in the
valuation of fixed assets will be reflected
as a of funds on the sources and
uses of funds statement.

7 18. Conversely, any increase in the


sale valuation of the fixed assets will indicate
source the outflow of money for the purchase
of fixed assets, and will therefore be
reflected on a sources and uses of funds
statement under the of

I8 19. The figures we enter on the sources


uses and uses of funds statement are cal-
funds culated from the valuation of the fixed
assets before depreciation has been
deducted.
Looking again at Panel E, we see that
the valuation of the fixed assets (before
depreciation has been deducted) has
increased from 24,800 in 1983 to 26,200
in I 984. In other words, funds have been
used to purchase fixed assets during the
year. Therefore, the figure we should .

enter under the uses of funds is 26,200—


24,800 =

85
How to read a balance sheet

•CHECK FRAME YOUR ANSWER

19 20. Although depreciation is a sum of


1,400 money deducted from the valuation of
(the increase in the on the balance sheet,
valuation this money is not actually spent but is
of fixed assets retained by the company.
before depreciation)

20 2 I. Depreciation is a provision made


fixed assets on the balance sheet for the expenses .

which will be involved when


equipment has to be bought to replace
old equipment.
The money however [does/does not]
leave the business until the new assets are
actually bought.

21 22. Until the new fixed assets are


new bought, then, the company has the funds
does not identified as depreciation available to it.
The figure for depreciation therefore
reflects a [source/use] of funds.

22 23. Returning to Panel E. once more we


source see that in preparing a sources and uses of
funds statement for this balance sheet we
would enter a sum of (7,220 —
4,600) in respect of depreciation under
the sources of funds; and at the same
• time we would enter a sum of 1,400 in
respect of the purchase of fixed assets
under the of funds.

23 24. Note that we would enter 2,620 for


2,620 depreciation, and not 7,220 since in the
uses sources and uses of funds statement we
are concerned only with the
pccurring between one balance sheet and
the next.

86
The overall balance sheet

CHECK FRAME YOUR ANSWER

24 25. The figure on the balance sheet for


changes earned surplus reflects the accumulated
profits of a company after dividends have
been paid. Any increase in the earned
surplus from one year to the next thus
reflects profits retained in the business
and this is clearly a [source/use] of funds
for the enterprise.

25 26. On the balance sheet on Panel E,


source we can see that the increase in earned
surplus between 1983 and 1984 was
(17,566— 11,300) units.

26 27. This of funds, together


6,266 with that part of the profit that was set
aside for the payment of dividends, would
be reflected in the sources and uses of
funds statement under "net profit for the
period". In this case, the sum set aside for
dividends was 5,000 units. So the net
profit was 11,266 (6,266 + )
units. (In Set 12 on the profit and loss
account you will see how the figure for
net profit is worked out.)

27 28. It is at the discretion of a company's


source directors whether profits are retained in
5,000 the business or paid out to shareholders
in the form of . Money paid out as
dividends represents an outflow of
money and would be reflected on a
sources and uses of funds statement as
one of the of

.28 29. And finally we come to the most


dividends difficult part: working capital. You may
uses remember that in Set 8 we defined
• funds working capital as equal to current
minus liabilities.

87
How to read a balance sheet

CHECK FRAME YOUR ANSWER

29 30. Working capital equals current


assets assets minus current liabilities. We can
current see from this formula that if current
assets increase and current liabilities do
not (or at least if current liabilities
increase by less than the
have done), then working capital will
increase.

30 31. What sort of situation results in an


current assets increase in current assets?
One example would be increased
inventory; another example would be
increased receivables. In either case
money is not coming in, but rather is
being used for some purpose.
Now as we saw in the previous frame,
an increase in current assets (when
money is being ) will usually
result in an increase in

• 31 32. We can thus see that an increase in


used working capital would be entered on the
working capital sources and uses of funds statement as a
of funds.

32 33. To make these relationships more


use clear, let us go back to frame 30 and the
formula: working capital equals current
assets minus current
We saw there that if current assets
increase, capital will tend to
increase.

33 34. Now if current assets decrease,


liabilities working will also decrease
working (unless current liabilities go down by an
even greater amount).

88
The overall balance sheet

CHECK FRAME YOUR ANSWER

34 35. Current assets decrease when, for


capital example, inventories and receivables
become lower. However, if one current
asset changes for another (e.g. accounts
receivable are settled in cash), this does
• not change the total current assets. Thus,
. only a decrease in total current .

causes an inflow of funds.

35 36. As we saw in frame 34, when


assets current assets decrease, working capital
will also tend to . So a decrease in
working capital means an inflow of funds,
and any decrease in working capital
would be entered on the sources and uses
of funds statement as a of
funds.

36 37. In preparing a sources and uses of


decrease funds statement we need to calculate
source how the amount of working capital has
from one balance sheet to the
next.

37 38. Let us do this for the balance


changed sheet figures shown on Panel E. As at
31 December 1983, working capital
335,400— =

38 39. As at 3 I December 1984, working


178,860 capital = — 82,974 =
156,540

39 40. So, from 3 I December 1983 to


267,000 3I December 1984, working capital
184,026 [increased/decreased] by 184,026 —
156,540=

89
How to read a balance sheet

CHECK FRAME YOUR ANSWER

40 41. On a sources and uses of funds


increased statement we would therefore reflect an
27486 increase in working capital of 27,486 as
one of the fsources/uses] of funds.

41 42. Finally, let us put all this together


uses in a concise statement. Look at the
following sources and uses of funds
statement and fill in the missing words or
figures where indicated by referring back
to the calculations we have carried out in
the earlier frames of this set.

HOUSEHOLD UTENSILS LTD.


Sources and uses of funds statement
for the year to 3! December 1984
(expressed in WCU)

SOURCES OF FUNDS
Net profit for the period (after
depreciation charged) II 266
(a) (added back) 2 620
New share capital issued (b)
Total sources of new funds 33 886

USES OF FUNDS
Dividends paid 5 000
Purchase of fixed assets I 400
(c) in net working capital (d)
Total uses of new funds 33 886

NET WORKING CAPITAL


COMPUTATION
1983 1984
Current assets 335 400 267 000
Current liabilities 178 860 82974
156540 184026
Increase in net working capital 27 486

90
The overall balance sheet

CHECK FRAME YOUR ANSWER

42 43. The sources of funds were:


(a) Depreciation Net profit
(b) 20,000 Depreciation
(c) Increase
New capital
Total 33 886

43 44. The uses of funds were:


11,266 Dividends
Fixed assets purchased
Increase in net working capital
Total 33 886

44 45. Thus, the sources and uses of funds


5,000 statement reveals the key
1,400 management decisions during the
27,486 period.

45 You have now reached the end of the


financial most difficult set in the book. Perhaps you
should take a good break. Before trying
the next chapter, enter the usual data on
the Progress Work Sheet, read the
summary for this set again and then tackle
the mini-test on Chapter 4.

9!
How to read a balance sheet

92
______

PANEL E

HOUSEHOLD UTENSILS LTD.


Balance sheet at 31 December 1984 (expressed in WCU)

ASSETS 3! Dec. 1983 3! Dec. 1984 LIABILITIES 31 Dec. 1983 31 Dec. 1984

Current assets Current liabilities


Cash in banks Bank overdraft 84 160 10 520
Cash in hand 250 450 Trade accounts payable 81 000 60 002
250 450 Other accounts payable 8 000 6 000
Marketable securities (market value 2 110) 2 000 Provision for taxation 2810 3 755
Customers' accounts 261 000 180 000 Reserves for unbilled expenses 2 000 I 807
Deposits 550 550 Interest due on fixed liabilities 890 890
Employee accounts I 200 I 400 Total current liabilities 178860 82974
Other receivables 315 450
Prepaid expenses 200 350
265265 182750
Less provision for doubtful items (accounts) 11415 3200
253850 179550
Fixed liabilities
Inventories (at cost or market value, whichever is
the lower): Development bank loan at 10 per cent repayable
Finished products 30 500 29 200
2001 (secured on all current and fixed assets) 50000 50000
Work in progress I 200 I 800
Mortgage loan at 9 per cent, repayable 1995
(secured on the real estate) 8000 8000
Raw materials 50 100 56000
Total fixed liabilities 58000 58000
Other supplies 600 I 000
Total outside liabilities 236860 140974
82400 88 000
Less provision for inventory losses 1100 1000
81300 87000
Total current assets 335400 267000

Fixed assets Shareholders' funds


Land, at cost I 600 I 600 Capital authorised 200 000
Buildings, at cost I 000 I 000
Capital issued: in ordinary shares of 10 money units
Plant, machinery, etc., at cost 5 300 6 000 each IQO 000 120 000
Manufacturing tools, at cost 3 500 4 200 Capital surplus 8 440 8 440
Transport, at cost I 200 I 200 Earned surplus II 300 17 566
Furniture and fittings, at cost 2 200 2 200 Total shareholders' funds 119740 146006
24 800 26 200
Less depreciation 4 600 7 220
20200 18 980
Goodwill, at cost 1000 000
Total fixed assets 21 200 19 980
Total assets 356 600 286 980 Total liabilities 356600 286980

PANEL X — overleaf
______ ______

PANEL X

STEEL PRODUCTS LTD.

Balance sheet at 3! December 1984 (expressed in WCU)

ASSETS 31 Dec. 1983 31 Dec. 1984 L!AB!L!TIES 3! Dec. 1983 3! Dec. 1984

Current assets Current liabilities


Cash in banks and in hand l9l 190 Bank overdraft 6832 4858
Marketable securities, at cost: Trade accounts payable 7 179 7810
(market value at 31 Dec. 83: 750) 835 Other accounts payable I 127 962
(market value at 31 Dec. 84: 150) 110 Provision for taxation 93 628
Customers' accounts (allowance has been made for Reserves for unbilled expenses 400 386
doubtful debts) 9 685 8 729 Interest due on fixed liabilities 343 230
Employee accounts 120 109 Total current liabilities I 5 974 14 874
Other receivables and prepaid expenses 986 425
11626 9373
Inventories (at cost or market value, whichever is Fixed liabilities
the lower): Government loan secured on all current and fixed
Raw materials and supplies 5 400 7 675 assets at 5 per cent 9 500 5 000
Work in progress I 767 I 437 6 per cent loan stock 1985/90 3 500 3 500
Finished products 4 625 5 052 Total fixed liabilities 13 000 8 500
11792 14164
Total current assets 23 609 23 727
Shareholders' funds
Fixed assets Capital authorised 9 000
Freehold land and buildings, at cost 8 553 7 967 Capital issued: in ordinary shares of I money unit
Plant, machinery and equipment, at cost 36 852 31 728 each 7 873 8 000
45405 39695 Capital surplus 14393 13856
Less depreciation 14 920 I 3 233 Earned surplus 3 294 5 399
30 485 26 462 Total shareholders' funds 25 560 27 255
Patent rights, at cost 440 440
Total fixed assets 30 925 26 902
Total assets 54 534 50 629 Total liabilities 54 534 50 629
______________
______________ ______________
_______. _______________

The overall balance sheet

MINI-TEST ON CHAPTER 4
Now test yourself again. Check your answers and enter your results on
the Progress Work Sheet.

I An enterprise is said to be solvent if it can meet its out


ofits

2 An enterprise is said to be liquid if it can meet its out


ofits

3 Current assets — = working capital.

4 If a company has a gearing of 3, I per cent of its cost


of assets is financed by shareholders' funds. This gearing is
[high/low].

Open out Panel X opposite.

5 This gives the balance sheet of Ltd. at

6 This balance sheet also gives the figures at

7 Look at the company's position in December 1983. Was the


company solvent in December 1983? Why?

8 Was the company liquid in December 1983? . Why?

9 Is the company solvent in December 1984?

10 Is the company liquid in December 1984?

I Between December 1983 and December 1984 the total finance


employed by the company [increased/decreased] from to

12 The biggest change was in the [current liabilities/fixed


liabilities/shareholders' funds], which [increased/decreased] from
to

93
How to read a balance sheet

Answers to mini-test on Chapter 4

I outside liabilities; total assets.

2 current liabilities; current assets.

3 current liabilities.

4 25; high.

5 Steel Products; 31 December 1984.

6 31 December 1983.

7 Yes. Because the total assets were greater than the outside
liabilities.

8 Yes. Because the current assets were greater than the current
liabilities.

9 Yes.

10 Yes.

II decreased; 54,534; 50,629.

12 fixed liabilities; decreased; 13,000; 8,500.

94
_______
_______
_______
______________

The overall balance sheet

Mini-test (cont.)

13 The main group of assets showing the biggest change was the
assets; which [increased/decreasedi from to

14 Fill in the missing figures in the following table of liabilities for Steel
Products Ltd.:

December 1983 % December 1984 %

Current 29 Current 29
Fixed 24 Fixed 17

Shareholders' Shareholders'
funds 47 funds 54
Total 54 534 00 Total 50 629 100

15 In which year were the shareholders' funds a higher proportion of the


total finance: 1983 or 1984?

16 The sources and uses of funds statement gives details of where


money acciuired by an enterprise comes from, and what it has
been spent on.

17 Reduction of working capital is regarded as a of funds.

18 Which of the following is not a source of funds: new capital issued,


sale of fixed assets, increase in working capital and depreciation?

19 Any dividends paid by a company are a of funds.

20 A company whose total finance has increased from one balance sheet
to the next is always in a better financial position than one whose total
finance has not increased. True or false?

95
How to read a balance sheet

Answers (cont.)

13 fixed; decreased; 30,925; 26,902.

l4 15,974 14,874
13,000 8,500
25,560 27,255

IS 984.

16 new.

17 source.

I8 increase in working capital.

19 use.

20 False.

How were your re suIts?

More than IS Well done! Go straight on to Chapter 5.


correct?
I 0- I 5 correct? Reasonably good. Run over the summaries of Sets
8 and 9 before going further, however.
Fewer than IC This was a difficult chapter. Give yourself a break
correct? and then try the chapter again. It will seem much
easier next time.

96
MEASURING SOLVENCY 5
AND LIQUIDITY
5. SET 10. SOLVENCY
Estimated time: 25 minutes

Summary

Solvency is measured by the so'vency ratio expressed as a percentage.


The solvency ratio indicates the proportion of shareholders' funds in the
total liabilities. The higher the solvency ratio, the higher the proportion of
shareholders' funds in the total financing of the business.

When the business expands, the solvency ratio may either increase or
decrease depending upon the source of funds to finance the expansion.
Similarly, it may. increase or decrease when the company contracts.

It is the gearing of the company which shows how assets are financed by
shareholders' funds (owners' equity) or outside liabilities.

A high solvency ratio (high shareholders' funds) represents low gearing,


low risk and good potential for borrowing more outside finance (higher
debt capacity).

A low solvency ratio (low shareholders' funds) indicates high gearing, high
risk and less potential for borrowing more outside finance (lower debt
capacity).

9.
_______

How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. An enterprise is said to be solvent if


right? Check below, its total assets are greater than its outside
So the solvency of an enterprise
is its ability to meet its liab-
ilities.

I 2. Now, a company can be solvent to a


liabilities greater or lesser degree. The more the
outside relatively exceed the
the greater is the
degree of solvency.

2
total assets
outside liabilities

ASSETS % LIABILITIES %

Current assets 52 Current liabilities 26


Fixed assets 48 Fixed liabilities 9

45
— Shareholders' funds 55

Total assets 100 Total liabilities 100

3. If we want to compare an
enterprise's degree of solvency at two
dates, it is helpful to use ratios or
percentages. Look at the above table of
assets and liabilities; they are expressed
here as percentages.
The "solvency ratio" is a useful
measure of solvency and it is very
often expressed as a percentage. The
percentage used is the difference
between the total assets and the outside
liabilities.
From the above table we can work
out that the solvency ratio is
per cent less per cent =
per cent.

98
Measuring solvency and liquidity

CHECK FRAME YOUR ANSWER

3 4. Look at the table again: 55 per cent is


100, 45, 55 the proportion of in the
total liabilities.

4 5. In other words, the


shareholders' funds indicates the proportion of shareholders'
funds in the

5 6. The higher the solvency ratio, the


solvency ratio [higher/lower] is the proportion of
total liabilities (or in the total liabilities.
total finance)

6 7. Remember that the solvency ratio


higher also indicates how easily the enterprise
shareholders' funds can meet its liabilities out of its

7 8. Therefore the greater the pro-


outside portion of shareholders' funds in the total
total assets finance employed by the company, the
more easily can the company meet its
liabilities.

8 Let us now return to Panel E.


outside 9. Now, in December 1983 the
shareholders' funds were per
cent of the total finance. (Look at Set 8,
frame 24, if you cannot remember.)

9 10. Therefore the ratio in


33 December 1983 was per cent.

10 II. In December 1984, on the other


solvency hand, the shareholders' funds were
33 per cent of the total finance.
(Look at Set 8, frame 49, if necessary.)
Therefore the was
per cent.

99
How to read a balance sheet

CHECK FRAME YOUR ANSWER

II Ii. In 1984, then, the company had a


50 greater excess of over
solvency ratio than in 983. .

50

12 13. In other words, in 1984, the


total assets shareholders' funds were a
outside liabilities proportion of the than in
1983.

13
greater
total liabilities (or
total finance) COMPANY A
31 December 1982

ASSETS, % LIABILITIES %

Current assets 40 Current liabilities 25


Fixed assets 60 Fixed liabilities 25
Shareholders
— funds 50

Total assets 100 Total liabilities 00

14. Changes in the solvency ratio are


important, but as they can occur for a
number of reasons, we cannot draw
simple conclusions from such changes. As
we shall see, an increase in the solvency
ratio can be a sign either that the
enterprise is expanding or that it is
contracting. Similarly, we shall see that a
decrease in the solvency ratio can be
the result of either expansion or
contraction.
Look at the above table of assets
and liabilities given in percentages.
At 31 December 1982 we see that the
solvency ratio of Company A was
per cent.

100
_______________

Measuring solvency and liquidity

CHECK FRAME YOUR ANSWER

4 15. Now Company A was a successful


50 and profitable enterprise. In 1983 the
directors planned an expansion of its
trading activities and they retained a
substantial amount of the I 983 trading
profits in the business to finance this

I5
expansion

COMPANY A
LIABILITIES

31 Dec. 1982 31 Dec. 1983


Units % Units %

Current liabilities 4000 25 5000 25


Fixed liabilities 4000 25 4000 20
Shareholders funds:
Capital issued 5 000 5 000
Capital surplus I 000 I 000
Earned surplus 2 000 5 000
8000 50 11000 55
Total 16000 100 20000 100

16. The table above shows the liabilities


(in units and in percentages) of Company
A in both December 1982 and December
1983.
In December 1982 the solvency ratio
was per cent and in December
1983 it was per cent.

6 17. We can see what has caused this


50 change in the solvency ratio. First, the
55 total finance has [increased/decreased].
The current liabilities have increased to
some extent but the biggest single change
in the liabilities is that the
has increased from 2,000 to 5,000.

lO I
How to read a balance sheet

CHECK FRAME YOUR ANSWER

17 18. Those profits arising from normal


increased operations and retained in the business
earned surplus appear on the balance sheet under
surplus.

18 19. In this case, then, the main reason


earned for the increase in the solvency ratio is
that the has increased.

19 20. The earned surplus increased


earned surplus because more were retained in
the business to finance the of the
company's activities.

20 21. In other words, the solvency ratio


profits increased in this particular case because
expansion the company was

2I
expanding

cOMPANY A
LIABILITIES

Dec. 1982 Dec. 1983 Dec. 1984


Units % Units % Units %
Current liabilities 4000 25 5 000 25 5 000 22
Fixed liabilities 4000 25 4000 20 7 000 30
Shareholders'
funds:
Capital issued 5 000 5 000 5 000
Capital surplus I 000 I 000 I 000
Earned surplus 2000 5000 5000
8 000 50 I I 000 55 II 000 48
Total 16 000 I00 20000 00 23 000 100

102
Measuring solvency and liquidity

CHECK FRAME YOU R ANSWER

22. Now in the following year, 1984, •

Company A continued to expand.


As more funds were clearly needed to
finance this expansion, the management
considered various ways of acquiring
extra funds. They also considered the
relative costs involved.
The table for Company A on the
opposite page, which adds the liabilities at
the end of 1984 to the previous table,
shows how the management acquired the
extra finance that was needed for the
expansion of the company.
Between December I 983 and
December 1984 extra finance was
acquired by increasing the

22 23. In December 1982 the solvency


fixed liabilities ratio was per cent.
In December 1983 the solvency ratio
was per cent.
In December 1984 the solvency ratio
was per cent.

23 24. In other words, between 1982 and


50 1984 the solvency ratio of Company A
55 first [increased/decreased] and then
48 [increased/decreased).
Throughout the period, however, the
company was

24 25. Expansion of activities, then, can •

increased either or the solvency


decreased ratio.
expanding

103
_______ _______.
_______

How to read a balance sheet

CHECK FRAME YOUR ANSWER

25
increase
decrease

COMPANY B
LIABILITIES

Dec. 1982 Dec. 1983


Units Units
Current liabilities 5000 25 4000 25
Fixed liabilities 4000 20 4000 25
Shareholders'
funds:
Capital issued 6 000 6000
Earned surplus 5 000 2000
11000 55 8000 50
Total 20000 100 16000 100

26. Now consider Company B. This


is a failing company; its activities are
decreasing. In 1983 there was a trading
loss, and the declining activity resulted in
a change in the current liabilities. The
table above shows the liabilities for 1982
and 1983 (in units and in percentages).
Now, between December 1982 and
December 1983 the company's total
finance [increased/decreased]. The
current liabilities [increased/decreased]
and the trading loss resulted in a decrease
in the The solvency
ratio from per cent to
per cent.

26 27. In this particular case, then, a


decreased decrease in the solvency ratio ac-
decreased companied [expansion/contraction] of
earned surplus activities.
decreased
55
50 .

104
Measuring solvency and liquidity

CHECK FRAME YOUR ANSWER

27
contraction

COMPANY B
LIABILITIES

Dec. 1982 Dec. 1983 Dec. 1984


Units % Units % Units %

Current liabilities 5 000 25 4000 25 . 2000 I6


Fixed liabilities 4000 20 4000 25 4 000 32
Shareholders'
funds:
Capital issued 6 000 6 000 6 000
Earned surplus 5000 2000 500
I I 000 55 8 000 50 6 500 52
Total 20 000 100 16 000 00 12 500 100

Now, the next year Company B


continued to decline. There was a further
trading loss and a further general decline
in activities. The table above adds the
liabilities at December 1984 to the
previous table.
In December I 982 the solvency ratio
was per cent.
In December 1983 the solvency ratio
was per cent.
In December 1984 the solvency ratio
was per cent.
In other words, during this period it
is clear that the solvency ratio first
[decreased/increased], then
[decreased/increased].

28 29. Throughout the period, however, it


55 is evident that the company was
50 [expanding/contracting].
52
decreased
increased

los
How to read a balance sheet

CHECK FRAME YOUR ANSWER

29 30. To sum up, a contraction of


contracting business activity may result in either
in the solvency ratio.

30 31. Similarly, an of business


an increase or a activity may result in either an increase or
decrease a decrease in the

31
expansion COMPANY C
solvency ratio LIABILITIES

Dec. 1983 Dec. 1984


Units Units
Current liabilities:
Bank overdraft 6000
Other 4000 4000
0000 28 4000 12
Fixed liabilities 12000 34 12000 34
Shareholders' funds:
Capital issued 0000 6 000
Earned surplus 3 000 3 000
3000 38 9000 54
Total 35000 100 35000 100

32. A change in the solvency ratio,


then, may indicate a change in the degree
of activity of an enterprise. On the other
hand, the solvency ratio may change as
a result of a change in the financial
structure of an enterprise.
In December I 983 Company C had a
bank overdraft at a rate of interest higher
than the average rate of dividends paid to
shareholders. The table above shows the
liabilities of Company C for 1983 and
1984, in units and percentages.
In this case, the total finance
[changed/did not change] between
December 1983 and December 1984.

106
Measuring solvency and liquidity

CHECK FRAME YOUR ANSWER

32 33. The solvency ratio from


did not change per cent to per cent.
This increase in the solvency ratio
resulted from two things: a decrease of
(figures) in the
liabilities, and an increase of
(figures) in the

33 34. In other words, between Dec-


increased ember 1983 and December 1984 the
38, 54 company issued more and paid
6,000 off its
current
6,000
shareholders' funds
(or capital issued)

34 35. This meant that the company had


capital to pay no on bank overdraft; on
bank overdraft the other hand it had to pay to
more shareholders.

35 36. The rate of interest on the


interest overdraft, however, was higher than
dividends the average dividend rate. Therefore the
action of the management in reducing
the current liabilities and increasing
the capital issued meant that the overall
cost of the company's finance was
[increased/reduced].

36 37. Finally, think this over: high gearing


reduced is associated with [high/low] owners'
equity.

37 38. Low gearing is associated with high


low owners' equity and [high/low] risk,
because a company can easily borrow
more money.

107
How to read a balance sheet

CHECK FRAME YOUR ANSWER

38 39. High financial risk relates to


low [high/low] gearing, because it is difficult
to borrow more money when existing
liabilities already exceed funds.

39 40. With high gearing the owners'


high equity is [high/low] and the outside
shareholders' liabilities are [high/low].

40 That completes another set. Now note .

low the time you took and the number of


high frames in which you made a mistake.
We are now well over half-way
through the programme. Perhaps you
should read all the summaries again to
convince yourself how much you are
learning. Then go on to the next set.

108
Measuring solvency and liquidity

5. SET II. LIQUIDITY


Estimated time: 20 minutes

Summary

The current ratio and the quick ratio are two measures of liquidity:

current ratio = current assets : current liabilities


quick ratio = quick assets : current liabilities

The current ratio measures general liquidity but the quick ratio measures
immediate liquidity.

If the current ratio is lower than I : I (e.g. 0.5 : I, which can also be
expressed as I : 2), current liabilities exceed current assets. This

generally shows that there is a high financial risk because, in business, cash
is more important than profit.

If the current ratio is too high (perhaps 3 : I or more) this may mean that
the company has more money than it can efficiently use. There is no hard
and fast rule about a ratio being too high, but when it rises continually
over time the situation should be examined.

109
How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. A company or business enterprise


right? Check below, will have to meet its current liabilities in
the [short/long] term; it is important,
therefore, that there should be enough
assets to cover the current
liabilities.

I 2. A company is said to be liquid if


short its current assets exceed its current
current liabilities. The liquidity of an enterprise is
thus a measure of its ability to meet its
liabilities out of its current .

2 3. If a company cannot meet its current


current liabilities from its current assets then it is
assets not

3 4. Now, an enterprise can be liquid to a


liquid greater or lesser degree. There are two
ratios which provide useful measures of
the degree of liquidity of a company
or business enterprise. These are the
current ratio and the quick ratio. They
are both measures of

4 5. The current ratio and the quick ratio


liquidity are both measures of liquidity, in other
words, they are of the company's
ability to meet its current liabilities.

S 6. The current ratio indicates to what


measures extent the enterprise can meet its current
out of its current assets.

6 7. The quick ratio indicates to what


liabilities extent the enterprise can meet its
liabilities out of its quick assets.

•110
_______
_________ _______

Measuring solvency and liquidity

CHECK FRAME YOUR ANSWER

7 8. Remember that the quick assets are


current part of the current assets. They are cash
and those assets which can be
converted into cash. They [do/do not]
include stocks (inventories).

8 9. The relationship between current


quickly assets and current and between
do not quick and current liabilities could
be expressed as percentages, but in
accounting practice they are normally
expressed as ratios, e.g. 2 :

9 current assets
10. Current ratio = :
liabilities current
assets

10 . quick
Quick ratio = :
liabilities current liabilities

assets
COMPANY D

Balance sheet at 3! December 1984


(expressed in WCU)

ASSETS LIABILITIES
Quick assets I 000 Current liabilities I 000
Inventories 2 000 Fixed liabilities 5 000
Fixed assets 8 000 Shareholders' funds 5 000
Total I I 000 Total I I 000

12. From the simple balance sheet


above, calculate the current ratio:
current
Current ratio = :

liabilities
— 1,000÷2,000.
1—31
1,000

III
How to read a balance sheet

CHECK FRAME YOUR ANSWER

12 13. Referring back to the balance sheet


assets in the previous frame:
current assets
Quick ratio = :

liabilities
— 1,000
I—I
1,000

3 14. The quick ratio and the


quick are measures of They
current are both concerned with an enterprise's
ability to meet its

14 15. The current ratio indicates the


current ratio ability to meet out of
liquidity the quick ratio indicates
current liabilities the ability to meet current liabilities out of

5 16. Now let us return to the balance


current liabilities sheet on Panel E, and work out the
current assets current ratio for Household Utensils Ltd.
quick assets in 1983 and 1984. To get the current
ratio, we divide the by
the current liabilities, and to get the quick
ratio we divide the quick assets by the

16 Il. Fill in the words:


current assets
current liabilities Current ratio = :

(In each case, divide


by the current Quick ratio :

liabilities.)

7 18. In December 1983 the current


current assets ratio was:
current liabilities
quick assets — I 88
(figures) —
current liabilities

112
Measuring solvency and liquidity

CHECK FRAME YOUR ANSWER

18 19. In December 1984 the current


335,400 ratio is:
78,860 ,ç
= 3 22
(figures)

19 20. In 1983 the quick ratio was:


267,000 + (figures)
82974 = 1.42: I

, (figures)

20 21. In 1984 the quick ratio is:


250 + (figures)
= 2.17:1
(figures)

21 22. In 1984 the current ratio is


450 [higher/lower] than in 1983, and in 1984
179,550 the quick ratio is [higher/lower] than in
82,974 1983.

22 23. This means that in 1984 the


higher company had a relatively greater excess
higher of current assets over
and also a relatively greater excess of
over

23 24. The current ratio is a particularly


current liabilities important measure of the of a
quick assets business enterprise, and we go on now to
current liabilities consider some of the things it can tell
us about the state of a company's
finances.

24 25. If the current ratio happens to be


liquidity exactly I , this means that the value of
: I

the current assets [equals/does not equal]


the value of the current liabilities.

113
How to read a balance sheet

CHECK FRAME YOUR ANSWER

25 26. If the current ratio is lower than


equals I : I (e.g. 0.8 : I), this means that the
are greater than the

26 27. As a general rule, it is dangerous to


current liabilities let the current liabilities exceed the
current assets current assets, because the company
might be unable

27 28. If the current ratio is above I, this


to meet its means that the are
obligations. (or greater than the
similar words)

28 29. Now some current assets can be


current assets converted into less easily than
current liabilities others.

29 30. Therefore, in order to feel con-


cash fIdent about meeting current liabilities at
short notice, a sensible management will
make sure that the current assets are
than the current liabilities. .

30 31. In other words, the current ratio


greater should generally be than I :

On the other hand, if the current ratio is


as high as 3 I, this may suggest that the
finances of the company need to be
reorganised.

31 32. A current ratio of 3 : I means that


higher the value of the is three
times greater than the value of the .

I 14
_______ _______
_______
_______

Measuring solvency and liquidity

CHECK FRAME YOUR ANSWER

32 33. A great excess of current assets


current assets over current liabilities may mean that a
current liabilities company has more finance than it needs
and is putting its excess money into
unnecessary current

33 34. The company may, for instance, be


assets holding too much in the banks.

34 .35. Again, for example, the company


cash may be tying up its excess money in large
stocks of raw materials, etc., or in giving
long credits to its customers.
If the current ratio is very high, then,
this may be because the company has too
much available.

35 36. In other words, the company has


finance or money more than it can use efficiently.

36
finance ASSETS LIABILITIES
Current assets 14000 Current liabilities (average
Fixed assets 18000 interest: per cent)
I 2000
Fixed liabilities
(interest: 8 per cent) 13000
Shareholders' funds
(dividend: 10 percent) 17000
Total 32000 Total 32 000

37. There are other reasons why a high


current ratio may indicate a need for a
financialreorganisation. Look at the
above table of assets and liabilities, for
example. /
In this case the current ratio is found
from the formuta: (figure)
(figure)
which gives a ratio of : I.

115
How to read a balance sheet

CHECK FRAME YOUR ANSWER

37 38. In this particular case the company


4000 is able to make use of all its finances. But
2,000 the high current ratio still reflects an
7 unsatisfactory situation. Consider how
the company has obtained its finances.
It has a relatively [small/large] amount
of current liabilities at [high/low] interest
rates. It has a [small/large] amount of
fixed liabilities and shareholders' money
at [high/low] cost.

38 39. In other words the company has


small acquired too much [cheap/expensive]
low finance, and has not acquired enough
large [cheap/expensive] finance.
high

39 40. In this case, then, the company


expensive cannot take advantage of the cheap
cheap short-term finance available because it
has raised too much expensive
permanent and -
finance.

40 41. There are various other reasons


long-term . why the current ratio may be high. If a
company's current ratio rises over a
period, then the situation needs to be
examined. It may be, however, that there
are special circumstances which justify a
high current

41 And that brings us to the end of Chapter


ratio 5. Note the time you took and the
number of frames in which you made a
mistake before reading the summary for
this set once more. Do the mini-test and
then go on to the next chapter.

116
________________ ________________

Measuring solvency and liquidity

MINI-TEST ON CHAPTER 5
Now, how much have you remembered about this chapter as a whole? As
usual, do all the questions below and then check your answers,

I Here is a table of assets and liabilities. What is the solvency ratio?


per cent.

ASSETS % LIABILITIES %

Current assets 48 Current liabilities 30


Fixed assets 52 Fixed liabilities 34
— Shareholders' funds 36
Total assets 100 Total liabilities 00

2 The solvency ratio indicates how easily an enterprise can meet its
out of its

3 The solvency ratio also indicates the proportion of______________ in


the

31 Dec. 1983 31 Dec. 1984


Units % Units %

Current liabilities
Bank overdraft 6000 4000
Others 4000
10000 28 4000 12
Fixed liabilities 12 000 34 12 000 34
Shareholders' funds:
Capital issued 10 000 16 000
Earned surplus 3 000 3 000
13000 38 19000 54
Total 35000 00 35000 100

4 This table of liabilities shows that the solvency ratio


[increased/decreased] from per cent in December 1983
to per cent in December 1984.

117
How to read a balance sheet

Answers to mini-test on Chapter S

I 36.

2 outside liabilities; total assets.

3 shareholders funds; total finance (or total liabilities).

4 increased; 38; 54.

118
_______ ______________
_____________________
_______________
_______
_______
_______

Measuring solvency and liquidity

Mini-test (cont.)

5 An increased solvency ratio:


(I) always indicates that the enterprise is expanding;
(2) may result from either expansion or contraction of the
business.
Indicate whether you think (I) or (2) correct,

6 Look at the table of liabilities again. What are two reasons for the
change in the solvency ratio?

7 The current ratio and the quick ratio are measures of

8 The current ratio indicates the ability to meet out of

9 The quick ratio indicates the ability to meet out of

10 Current ratio = : I (Fill in the correct words.)

I I Quick ratio = : I (Fill in the correct words.)

12 If the current ratio = I : I this means that =

I3 It is dangerous for the current ratio to be lower than . The


current ratio [should/should not] be higher than I. I :

14 If the current ratio is very high this may mean that the of the
enterprise should be reorganised. A high current ratio may mean that
an enterprise has too much available.

I 5 Another reason for a high current ratio could be that the enter-
prise has too much [cheap/expensive] finance and not enough
[cheap/expensive] finance. The [current/quick] ratio gives the best
indication of ability to meet current liabilities at short notice.

119
How to read a balance sheet

Answers (cont.)

5 (2).

6 Current liabilities have decreased and shareholders' funds have


increased; or more capital has been issued and bank overdraft has
been paid off.

7 liquidity.

8 current liabilities; current assets.

9 current liabilities; quick assets.


current assets
10
current liabilities

quick assets
I

current liabilities
I 2 current assets; current liabilities.

13 I : I; should.

14 finances; finance or money.

15 expensive; cheap; quick.

120
______________

Measuring solvency and liquidity

Mini-test (cont.)

Now pull out Panel X (page 93) and answer the following questions about
the liquidity of Steel Products Ltd. as at 31 December 1984.

I6 In December 1983 the current ratio was = I .48:

17 In December 1984 the current ratio was = 1.60:

• +
= .74:

18 In December 1983 the quick ratio was I

• ÷
= .64:

19 In December 1984 the quick ratio was

20 From these quick ratios we can see that the were not
covered by the in either December 1983 or
December 1984.

12!
How to read a balance sheet

Answers (cont.)

23,609
16 1983:
15,974

23,727
17 1984:
14,874

191 + 11,626
18 1983:
15,974

190 ÷ 9,373
19 1984:
14,874

20 current liabilities; quick assets.

How did you manage this time?

More than I 5 Very good. You are ready to start Chapter 6.


correct?
10-15 correct? Quite good (especially if you got 14 or IS). But
read through the summaries of Sets 10 and II
before proceeding further.
Fewer than 10 Take a good break before starting Chapter 5
correct? again.

122
PROFITABILITY 6

6. SET 12. THE PROFIT AND LOSS ACCOUNT


Estimated time: 20 minutes

Summary

A balance sheet shows assets and how they are financed at a particular
date; it needs to be supplemented by a document showing activity: sales,
costs, profit or loss made during the financial year to the date of the
balance sheet. Such a document, which is usually attached to the balance
sheet, is known as a profit and loss account (or income statement).
Four different types of profit are given in the profit and loss account:
gross profit, operating profit, profit before tax, and net profit after tax.
A company generally gets profits from the sale of goods and services.
Some of this money, however, has to be spent on raw materials, wages
and factory overhead costs for producing the goods and services. The
difference between the money received from sales and the costs directly
involved in producing the items sold (the cost of sales) is known as the
gross profit.
Thus: sales — cost of sales = gross profit (GP).

Additional expenses are incurred in running the business enterprise as a


whole, e.g. office staff, stationery, telephone charges, sales force, and so
on; these are termed "operating expenses".
Thus: gross profit — operating expenses = operating profit (OP).

A business may incur further expenses not directly connected with its
day-to-day operations, e.g. interest payments on loans, purchase of
goodwill, losses on the sale of investments and fixed assets, etc. These are
termed "non-operating expenses".
Thus: operating profit — non-operating expenses = profIt before tax
(PBT).

Income tax must be paid on the profits of a company in most countries;


this further reduces the final amount of profit which is available for
distribution to the shareholders as dividends or which is retained in the
company and carried over as earned surplus.
Thus: profit before tax — income tax net profit (net income, net
earnings).

123
How to read a balance sheet

A separate statement, the statement of earned surplus (or retained


earnings), records the earned surplus brought forward, plus the net profit
for the year, less the dividends paid. The balance is the figure for earned
surplus which is carried forward to the next year on the balance sheet.
Any other charges noted in this statement of earned surplus must be
investigated and are probably explained in the notes to the financial
statements.

124
Profitability

CHECK FRAME YOUR ANSWER

Is your answer I. Companies are in business to make


right? Check below, profits. The most useful overall measure
of the condition of a is therefore
its profitability.

I 2. The profitability of an enterprise is


company the relationship between the
made and the total finance employed to
make that profit.

2 3. A balance sheet is a statement of


profit what a company and what it
at a particular point in time. It
[gives/does not give] a clear statement of
the profit made during the year.

3 4. Therefore, to assess profitability


owns during any year we need, in addition to
owes the balance sheet, details about the
does not give made during the year.

4 5. Most companies provide information


profit about the profit they have made during
the year in a document attached to the
balance sheet, called the profit and loss
account (or income statement). Are a
balance sheet and a profit and loss
account the same thing?

5 6. The total assets and liabilities are


No constantly changing, so the
must be a statement about what
these totals are on a particular day.

6 7. The profit and account


balance sheet is very different. It summarises the
company's operations and the profit (if
any) it has made, during a period of time
(usually a year). It [is/is not] a statement
of the position on one particular day.

125
How to read a balance sheet

CHECK FRAME YOUR ANSWER

7 8. A balance sheet will be given a


loss heading like "Balance sheet at 3 I Dec-
1s not ember 1983'.
A and account, on the
other hand, will be headed "for the year
ended 31 December 1983" (or "for the
six months ended 30 june 1984").

8 9. Would we find a profit and loss


profit account headed "at 3I December
loss 1983"?

9 (0. In this set we shall examine the


No and loss account briefly before
(It would be given a going on in the next set to see how we use
heading like "for the the information it contains to compute
year ended 31 Dec- measures of profitability of a business
ember 1983.) enterprise.

10 Open out Panel F at page 140 before


profit continuing.
II. Panel F gives the profit and loss
provided by Household Utensils
Ltd. with its balance sheet dated 3 I Dec-
ember 1984 (Panel E).

II Ii. This account shows us clearly how


account were made during 1983 and
and what happened to them.

12 13. The primary source of all profits is .

profits in goods or services actually sold. Finished


1984 products completed during the financial
year but not actually sold [do/do noti
contribute to profits in that year.

126
Profitability

CHECK FRAME YOUR ANSWER

13 14. Obviously, not all of the money


do not received from sates is profit, since the
goods cost something to make. The
amount of money received from sales less
the amount spent in producing the goods
sold (the cost of sales) = gross

14 15. From the profit and loss account on


profit Panel F we can see that Household
Utensils Ltd. [increased/decreased] its
gross profit from 1983 to 1984.

IS 16. Expenses directly involved in


decreased producing the goods sold (such as the
. cost of raw materials and the wages of the
workforce producing the goods) make
up the cost of

.16 Il. Apart from the expenses directly


sales involved in producing the items sold (the
of sales), a company is involved
in many other expenses in keeping
its day-to-day operations running. For
example, it may have a team of salesmen,
probably an office staff, and almost
certainly routine office expenses
(stationery, postage, telephones, etc.).
All these operating expenses must be
paid for out of the gross

17 18. The money left out of the gross


cost profit once operating have been
profit paid is referred to as the operating
profit.

lB 19. Gross profit — =


expenses . profit.

127
How to read a balance sheet

CHECK FRAME YOUR ANSWER

19 20. To summarise what we have said so


operating expenses far: when we subtract the cost of_______
operating and operating from the total
income derived from sales, we have the
company's operating profit.

20 21. Look again at Pane! F and note


sales how the operating profit of Household
expenses Utensils Ltd. has from I 983 to
1984.

21 22. Gross profits have but


increased operating profits have increased. This is
because the company's
have decreased substantially from 1983
to 1984.

22 23. However, to stay in business, the


decreased company must meet expenses over and
operating expenses above those directly involved in
producing the goods sold and in keeping
its plant and machinery operating. In
other words, it must meet expenses other
than the cost of and
expenses.

23 24. Because these other expenses do


sales not arise directly from the day-to-day
operating operations of the company, they are
described as non-operating

24 25. Typical examples of expenses not


expenses arising directly from a company's day-
to-day operations are: interest paid on
loans, losses (if any) on the sale of fixed
assets and investments, and the purchase
of goodwill. These are all examples of
non- expenses.

28
Profitability

CHECK FRAME YOUR ANSWER

25 26. Looking again at Panel F, we see


operating that the non-operating expenses of
Household Utensils Ltd. [did/did not]
increase from 1983 to 1984.

26 27. What were these non-operating


did not expenses and how did they arise?
Looking at the profit and loss account on
Panel F we see that they amounted to
Looking at the related balance
sheet on Panel Ewe see that the company
has to pay interest at 10 per cent per
annum on a loan of 50,000 and at
per cent per annum on a loan of 8,000.

27 28. Annual interest payable thus equals:


5,720
lOx 50,000 9x8,000
= 5,000; = 720;

5,000 + 720 = = the company's


non-operating expenses. (We have
already calculated this — see Set 5, frame
34.)

28 29. When non-operating expenses are


5,720 deducted from the operating , we
have the figure for profit before tax.
Operating profit — non-operating
expenses profit

29 30. To summarise again what we have


profit said so far: gross profit = sales — cost of
before tax operating profit = sales — cost of
' sates — and
before = sales — cost of sales —
operating expenses — non-operating
expenses.

129
How to read a balance sheet

CHECK FRAME YOUR ANSWER

30 31. In almost every country of the


sales world, companies have to pay tax on the
operating expenses profits they earn. This is only
profit paid some time after the end of the
tax company's financial year, but provision
has to be made for it from the profits
for that year.

3I 32. Tax payable is shown on the


tax balance sheet and on the profit and
On both Panel E and
Panel F we see that Household Utensils
Ltd. made a provision for taxation of
in 1983 and of 3,755 in

32 33. Profit before tax — tax = net


loss account after
2,810
1984

33 STATEMENT OF EARNED SURPLUS


profit 34. The net profit is
tax money available to the company for use
as the directors see fit. All of it may
be distributed to the owners of the
company, the , as dividends,
although this is very rarely done.

34 35. Most companies are expanding all


after tax the time and need extra funds to finance
shareholders their expansion. Usually some (or even
all) of the after tax will
be retained in the company to provide at
least part of the funds needed to finance
the expansion.

35 36. Profits retained in the company are


net profit added to the surplus.

130
Profitability

•CHECK FRAME YOUR ANSWER

36 37. Looking at the statement of earned


earned surplus for 1983 on Panel F, we see that
3000 units of net profit of 8,430 were
paid out as to shareholders and
the remaining units increased the
earned surplus account.

37 38. In 1984 units were paid out


dividends as dividends and 6,266 (11,266 — 5,000)
5,430 (8,430 — were retained in the company as
3,000) .

38 39. From the statement of earned sur-


5,000 plus on Panel F we see that net 5,430
earned surplus (8,430 — 3,000) units were added to the
earned surplus during 1983, and from the
balance sheet on Panel E we see that the
earned surplus at 3 I December I 983 was
At the end of 1982, therefore,
there must have been an earned surplus
of 11,300—5,430=

39 40. Since the earned surplus at 31


. 11,300 December 1983 was 11,300 (Panel E)
5,870 and was retained during 1984
(Panel F), earned surplus at the end of
1984 must have been 11,300 ÷ 6,266 =
which, as we see from the
balance sheet on Pane! E, was the case.

40 • That is the end of another set. Note the


6,266 time you took and the number of frames
7,566 in which you made a mistake. Then read
the summary for this set again, before
going on to try Set 13.

'3'
How to read a balance sheet

6. SET 13. TWO MEASURES OF PROFITABILITY


Estimated time: 20 minutes

Summary

There are two useful measures of the profitability of a business enter-


prise: return on total investment and return on shareholders' funds; they
are usually expressed as percentages:

profit interest on
before tax + fixed liabilities x 100
Return on total investment =
total investment

net profit after tax x 100


Return on shareholders funds =
shareholders funds
The figures for profit will be obtained from the profit and loss account and
the figures for total investment and shareholders' funds from the balance
sheet.

Total investment is generally defined as total assets less current liabilities.


This is the same as shareholders' funds plus long-term liabilities.

A financial ratio is like the financial "temperature" of a business; it is


"healthy" when it complies with normal accepted ratios for the industry
which are usually published each year by chambers of commerce,
industrial associations or the government.

132
Profitability

CHECK FRAME YOUR ANSWER

Is your answer RETURN ON TOTAL IN VESTMENT


right? Check below. I. By putting together information
from a company's balance sheet for a
certain date, and the and
account for the year ending on that date,
we can calculate the profitability of a
business enterprise.

I 2. There are various formulas which


profit can be used for this purpose. We shall
loss consider only two: those that give us a
measure of "return on total investment"
and "return on shareholders funds".
These are both measures of the
of a business enterprise.

2 3. Now, to operate a business and earn


profitability profits the management must have the
use of permanent and long-term finance.
This finance appears on the balance sheet
as funds and liabilities.

3 4. The shareholders' and the


shareholders' fixed represent finance invested
fixed in the company by shareholders and
others.

4 5. The shareholders' investment (or


funds shareholders' funds) is the money
liabilities subscribed by the shareholders, plus
p retained in the company.

5 6. Profits retained in the company are


profits credited to the shareholders. They are
added to the shareholders' funds and can
be regarded as part of the shareholders'
in the company.

133
How to read a balance sheet

CHECK FRAME YOUR ANSWER

6 7. The liabilities are also


investment investments in the company, but the
current liabilities are not investments.
The current liabilities represent credit
extended to the company on a
basis.

.7 8. The total investment in the company,


fixed then, is the plus the
short-term

8 9. One of the most useful overall


shareholders' funds measures of profitability is a ratio known
fixed liabilities as return on total investment. This ratio
gives a measure of the management's skill
in exploiting the invested in the
company.

9 tO. Now, return on total investment


funds (or money) indicates the relation between the
earned and the total investment
in the company.

10 II. In other words, the return on


profit investment is the return, or
profit, on the plus the

II Ii. The return on total investment is a


total measure of the skill of the in
shareholders' funds exploiting the funds made available by the
fixed liabilities investors.

12 13. The general formula for return on


management total investment is:
return
total investment.
Now, we have already seen that total
investment is +

134
Profitability

CHECK FRAME YOUR ANSWER

13 14. Let us now find out what the word


shareholders' funds the top line of this formula
fixed liabilities means. Remember that this ratio is an
overall measure of the skill of the
management.

14 IS. Now, the management has no


return control over the amount of profits tax
that is paid on the profits. Therefore
the fairest indication of how profitable
the enterprise has been is profit
[before/after] tax.

15 16. The basic part of the "return" in


before the formula above, then, is profit

16 17. Now, the figure for profit before


before tax tax is the figure for profit [before/after]
dividends are paid to shareholders. (Look
at Panel F if you are not sure.)

17 18. In other words, profit before tax


before includes compensation to be paid to
for their investment.

18 19. Now, total investment, remember,


shareholders means +

19 20. Therefore, if "return" includes


shareholders' funds compensation to be paid to shareholders
fixed liabilities it should also include compensation paid
onthe

20 21. In this formula, therefore, "return"


fixed liabilities should include the i_______ on the fixed
liabilities.

'35
How to read a balance sheet

CHECK FRAME YOUR ANSWER

21 22. Does the figure for profit before


interest tax include the interest on the fixed
liabilities? (Look at Panel F if
you are not sure.)

22 23. The interest on the fixed liabilities


No together with other expenses make up
the non-operating expenses which are
deducted from the operating profit to
arrive at the figure for profit
So profit before tax [does/does
not] include interest on fixed liabilities.

23 24. But "return" in our formula should


before tax include the interest on the fixed liabilities.
does not Therefore, this interest should be added
to the profit before tax in calculating the
"return". Return = profit before tax +

24 25. Now, complete the formula for


interest on fixed return on total investment which is:
liabilities
return
total investment
where return = profit tax +
interest on
and total investment
+

25 26. The return on total investment


before ratio is usually expressed as a per-
fixed liabilities centage: .

shareholders' funds
fixed liabilities
return x 100
total investment
In other words, before tax +
interest on fixed liabilities x 100 is divided
by + fixed liabilities.

136
Profitability

CHECK FRAME YOUR ANSWER

26 27. In working out the return on total


profit investment we can find the figure for
shareholders funds profit before tax from the [balance
sheet/profit and loss account]. The
figures for shareholders' funds and fixed
liabilities will come from the

27 28. The remaining figure we will have


profit and loss to find is the on
account liabilities. Can we always get this figure
balance sheet from the profit and loss account?

28 29. You can work out the annual


interest interest on the fixed liabilities, however,
fixed from the information given in the
No
(The figure for
non-operating
expenses includes
interest on fixed
liabilities but
may include
other items as well.) .

29 30. Look at the balance sheet for our .

balance sheet company on Panel E. In 1984 the total


annual interest on the fixed liabilities is
per cent on plus
per cent on

30 31. In 1984 the interest on the fixed


10 liabilities is 5,000 + 720 = 5,720.
50,000 The interest on the fixed liabilities in
9 1983 was [the same/not the same] as in
8,000 1984.

.137
How to read a balance sheet

CHECK FRAME YOUR ANSWER

31 32. Look at Panel E and Panel F and fill


the same in the missing figures below. For 1983
the return on total investment (as a
percentage) was:
+ )x100 = 9.54 per cent
+

32 33. For 1984 the return on total


I 1.240 + 5,720 investment (as a percentage) was:
119,740 + 58,000
(___+.__)x 100 = 10.17 percent

33 34. As shown by the return on total


15,021 + 5,720 investment, was the company more
146,006 + 58,000 profitable in 1983 or 1984?

34 35. In other words, the total


1984 permanent and long-term funds were
employed more by the
management in 1984.

35 36. To repeat, the formula for return


profitably (or on total investment is:
effectively)

36 RETURN ON SHAREHOLDERS' FUNDS


profit before tax + 37. We have seen that return on total
interest on fixed investment is a measure of the return on
liabilities the shareholders' investment (share-
shareholders' funds holders' funds) and the long-term invest-
fixed liabilities ment by other people (fixed liabilities). It
is a useful overall measure of the ability of
the

138
Profitability

CHECK FRAME YOUR ANSWER

37 38. Now, the ordinary shareholders


management may be particularly interested in the
return on their investment: in other
words, the return on the ordinary
alone.

38 39. The return on shareholders' funds


shareholders' funds (or shareholders' investment) in any one
year is the relation between the net profit
available for the shareholder and the total
shareholders' funds. That is:
Net available for
shareholders' funds

39 40. The part of the profit that is paid


profit as tax is obviously not available for the
shareholders shareholders: "net profit" in the above
formula, then, means net profit
[before/after] tax.

40 41. The figure for profit before tax, on


after the other hand, is used in working out the
return on t

41 42. Profit before tax is used in working


total investment out the return on total investment.
In working out the return on the
shareholders' funds, "return" means net
profit

42 43. Return on shareholders' funds


after tax return (i.e
shareholders' funds

43 44. Generally, the figure for net profit


net profit after tax after tax [can/cannoti be obtained from
the balance sheet.

'39
How to read a balance sheet

CHECK FRAME YOUR ANSWER

44 45. Fill in the missing figures below. We


cannot (but it are still referring to Household Utensils
should be given in Ltd. (the balance sheet is on Panel E, the
the profit and loss profit and loss account on Panel F). For
account) 1983 the return on shareholders' funds,
as a percentage, was:
x 100
= 7.04 per cent

45 46. For 1984 the return on the


8,430 shareholders' funds, as a percentage,
119,740 was:
x
= 7.72 per cent

46 47. From the shareholders' point of


11,266 x 100 view, then, was the return on investment
146,006 more satisfactory in 1983 or 1984?

47 48. Ratios are like thermometers which


1984 show the financial 'temperature" of the
business to determine whether it is
financially or not.

48 49. A healthy business today may not


healthy be healthy in the future. Thus, we must
forecast the future statements
and the future ratios.

49 50. Healthy ratios depend upon the


financial normal ratios for the industry which vary
over time and also according to the size
and type of the business. Normal ratios
are published by chambers of commerce
or industrial associations or sometimes by
theg

140
PANEL F

HOUSEHOLD UTENSILS LTD.


Profit and loss account
for the year ended 31 December /984
(compared with the year ended 3! December 1983)
(expressed in WCU)

1983 1984

Sales 221 762 198907


Cost of sales 154211 41 453
Gross profit 67551 57454

Operating expenses
Selling 27521 21328
Administration 18 090 10 512
General 4 980 4 873
50591 36713
Operating profit 16 960 20 741

Non-operating expenses 5 720 5 720


Profit before tax I I 240 I 5 021

Corporation tax 2 810 3 755


Net profit 8 430 II 266

STATEMENT OF EARNED SURPLUS

for the year ended 3! December 1984


(compared with the year ended 3! December 1983)

1983 1984

Balance brought forward 5 870 I I 300


Net profit for the year 8 430 I I 266
14300 22566

Less: Dividends paid 3 000 5 000


Balance carried forward to the balance sheet II 300 17 566
Profitability

CHECK FRAME YOUR ANSWER

50 That is the end of Set 13. Note the time


government you took and the number of frames in
which you made a mistake. Then read the
summary for this set again, before going
on to Set I 4, the shortest set in the
book.

141
How to read a balance sheet

6. SET 14. THE VALUATION OF AN ENTERPRISE


Estimated time: 10 minutes

Summary

Assessing the value of an enterprise is a complicated procedure. The aim


of this set is not to teach you how to value a business, but rather to point
out why you cannot value a business simply by examining its balance
sheet.

A business enterprise can be valued either as a "going concern" or as an


enterprise that will be wound up: for either purpose the information on
the balance sheet is inadequate.

If the business is to be wound up, we need to know how much cash will be
left when the assets have been sold and all the liabilities have been paid.
The balance sheet will not help us, because the fixed assets of a going
concern are valued at cost less accumulated depreciation; this may be
more or less than the realisable market value. Similarly, current assets are
valued at cost — or in the case of inventories at cost or market value,
whichever is the lower — in the ordinary course of business but not on
liquidation. Therefore, the balance sheet will not allow us to assess the net
worth of an enterprise that is to be wound up.

If the business is to continue as a going concern, the value of its assets will
be of less importance than its future profitability. In addition to past
performance, there are many factors not expressed in terms of money on
the balance sheet or profit and loss account that have an enormous effect
on the future profitability of the company. Some of these will be discussed
in Set 16, the final set.

Overall, the value of a business is determined only when it is actually sold.


The sales price may be more or less than the shareholders' funds shown
on the latest balance sheet. The value depends on future profitability and
on the realisable value of the assets if the business is wound up (the "asset
back-up" which prevents the "downside risk" of loss).

142
Profitability

CHECK FRAME Y OU R ANSWER

Is your answer I. We can consider the value of an


right? Check below, enterprise from two points of view: its
value as a "going concern" (that is, as an
enterprise that will continue to operate), :

or its as an enterprise that will be


wound up, or liquidated.

I 2. In either case it will be necessary to


value assess the worth of the enterprise. Net
worth is the value of the total assets, less •

those liabilities that the enterprise is


bound to meet. In other words, net worth
is total assets, less liabilities and
liabilities.

2 3. Now suppose that we want to know


current the value of an enterprise that is to be
fixed wound up.
First we have to see if we can discover
its net worth from the balance sheet. Net
worth, remember, means the difference
between the and the

3 4. We could look at the values given to


total assets the assets and the outside liabilities on
current and fixed the balance sheet. The figures against
liabilities (or outside the outside liabilities will probably be
liabilities) accurate, but what about the values
shown for the ? (Remember that
we are concerned with an enterprise that
is to be wound up.)

4 5. In the normal course of events, the


assets values shown for the assets on a balance
sheet are based on the assumption that
the enterprise will [continue to operate as
a going concern/be wound up]. •

143
How to read a balance sheet

CHECK FRAME YOUR ANSWER

5 6. A balance sheet [does/does not]


continue to operate indicate the "break-up" values of the
as a going concern assets, in other words, what the assets
could be sold for if the company ceased
operations.

6 7. If an enterprise is to be wound up,


does not then the balance sheet will not give a
reasonable indication of the value of the
assets. Therefore the balance sheet will
not allow us to assess the
of an enterprise that is to be wound
up.

7 8. Now, if we wanted to value a going


net worth concern (an enterprise that will continue
to operate), we would once again need to
know the net worth. In other words, we
would need to know the value of the
less the

8 9. Would the balance sheet give us a


total assets reasonable indication of the value of the
outside liabilities assets of a going concern?

9 10. The balance sheet will also show


Yes (The figures the outside liabilities. In all normal
would need some circumstances, then, the balance sheet
adjustment but will allow us to assess the
would give a a going concern.
reasonable
indication.)

10 II. But, when valuing an enterprise as a


net worth going concern it is necessary to consider
not only the net worth but also the
profitability of the enterprise.
In the last set we considered the
question of [past/future] profitability.

144
Profitability

CHECK FRAME YOUR ANSWER

II 12. In valuing an enterprise, however,


past profitability will be more im-
portant than past profitability.

12 13. In valuing an enterprise as a going


future concern, then, the two major factors to
be considered are and

13 14. As we shall discuss in the final set


net worth (Set I 6), future profitability depends on
future profitability a great number of factors, including the
qualities of the product, the activities
of competitors, the general economic
situation, and so on. Must we make
financial forecasts?

14 15. It [is/is not] possible to make an


Yes accurate assessment of future profit-
ability from a balance sheet.

IS That is the end of the shortest set in the


is not book. Note the time you took and the
number of frames in which you made a
mistake. Then read the summary for the
set once again before going on to test
your knowledge of the whole chapter in
the mini-test which follows.

145
_______ _______ ____________
_______________
_______________ _______

Profitability

MINI-TEST ON CHAPTER 6
Answer the questions below and when you have finished check your
answers on the Progress Work Sheet.

I Is it true that the balance sheet teUs us all that we need to know
about the financial position of a company or business enterprise?

2 A balance sheet is a statement about certain aspects of a business


enterprise's finances at a particular point in time, while a profit and
loss account is a statement about changes that have taken place
a period of time.

3 All the of a company are ultimately derived from goods or


services sold.

4 Sales — cost of sales =

5 Gross profit — operating expenses =

6 Payment of interest on long-term loans and purchase of goodwill are


examples of - a company might have to meet.

7 Operating profit — non-operating expenses =

8 Dividends are paid out of a company's net profit

9 Any of the net profits after tax not used in the payment of dividends
will be transferred to

10 Return on total investment and return on shareholders' funds are


measures of an enterprise's profitability. Return on total investment is
a useful overall measure of the ability of the

I By total investment we mean

+
12 Return on total investment =
+

13 Return on shareholders' funds

147
How to read a balance sheet

Answers to mini-test on Chapter 6

I No.

2 during.

3 profits.

4 gross profit.

5 operating profit.

6 non-operating expenses.

7 profit before tax.

8 after tax.

9 earned surplus.

10 management.

I shareholders' funds plus fixed liabilities.

profit before tax ÷ interest on fixed liabilities


12
shareholders' funds + fixed liabilities

net profit after tax


13
shareholders' funds

148
PANEL Y

STEEL PRODUCTS LTD. STEEL PRODUCTS LTD


Balance sheet at 31 December 1984 (expressed in WCU) Profit and loss account
for the year ended 31 December 1984
ASSETS 31 Dec. 1983 31 Dec. 1984 LIABILITIES 3! Dec. 1983 31 Dec. 1984 (compared with the year ended 3! December 1983)
(expressed in WCU)
Current assets Current liabilities
Cash in banks and in hand 191 190 Bank overdraft 6832 4858 1983 1984

Marketable securities, at cost: Trade accounts payable 7179 7810


Sales 8700 10419
(market value at 31 Dec. 83, 750) 835 Other accounts payable 1127 962
Cost of sales 5909 4 977
(market value at 31 Dec. 84, 150) I 10 Provision for taxation 93 628
Gross profit 2791 5 442
Customers accounts (allowance has been made for Reserves for unbilled expenses 400 386
doubtful debts) 9685 8729 Interest due on fixed liabilities 343 230 Operating expenses
Employee accounts 120 109 Total current liabilities 15974 14874 Selling 618
665
Other receivables and prepaid expenses 986 425
Administration 193 243
11626 9373 General 28 886 137 998
Inventories (at cost or market value, whichever is Fixed liabilities
Operating profit I 905 4 444
the lower): Government loan secured on all current and fixed
Raw materials and supplies 5400 7675 assets at 5 per cent 9500 5000 Non-operating expenses 304 924
Work in progress 1767 1437 6 per cent loan stock 1985/90 3500 3500 Profit before tax 601 3 520
Finished products 4625 5052 Total fixed liabilities 13000 8500
11792 14164 Corporation tax 93 628
Total current assets 23 609 23 727 Net profit after tax 508 2 892
Shareholders' funds
Capital authorised 9 000
Fixed assets
Capital issued: in ordinary shares of I money unit
Freehold land and buildings, at cost 8 553 7 967 7873 STATEMENT OF EARNED SURPLUS
each 8000
Plant, machinery and equipment, at cost 36852 31728 Capital surplus 14393 13856 for the year ended 31 December 1984
45 405 39695 Earned surplus 3294 5399 (compared with the year ended 3! December 1983)
Less depreciation 14 920 13233 Total shareholders' funds 25 560 27 255
30485 26462 1983 1984
Patent rights, at cost 440 440
Balance brought forward 3 573 3 294
Total fixed assets 30925 26 902
Net profit 508 2892
Total assets 54 534 50 629 Total liabilities 54534 50629
4081 6186

Less: Dividends paid 787 787


Balance carried forward to the balance sheet 3294 5399
_______
_______ _______
_______

Profitability

Mini-test (cant.)

Open out Panel Y: the balance sheet for Steel Products Ltd. at
3I December 1984 and the profit and loss account for 1983 and 1984.

14 Note that the dividends paid to shareholders in 1983 are


[greater/less] than the profit after tax for 1983. The dividends will
therefore have the effect of the earned surplus which had
accumulated by the end of 1982.
IS Now work out which was the more profitable year in terms of the
return on total investment. (Finish the job this time and work out the
percentages: work them out on a piece of paper.)

1983:
+ )x 100= = percent.

) x 100 =
1984: + + = per cent.

In terms of return on total investment, 1984 was [more/less]


profitable than 1983.
16 Now work out for each year the return on shareholders' funds.
x 100
1983: = = per cent.

x 100
1984: = = percent.

In other words, 1984 was [more/less] profitable than 1983 from the
shareholders' point of view.
17 When assessing the value of an enterprise, can we include the value of
the husband or wife of the accountant who always helps out with the
difficult figures?
18 The net worth of an enterprise that is to be wound up [can/cannot] be
assessed from the balance sheet.
19 When assessing the value of an enterprise as a going concern we need
to know both the net worth and the prospects of

20 Is the following statement correct or incorrect? It is possible to assess


the value of an enterprise from the balance sheet alone.

149
How to read a balance sheet

Answers (cont.)

14 greater; reducing.

(601 ÷685)x100 percent


l5
25,560+ 13,000 38,560

(3,520 + 460) x I00 = 398,000


= ii per cent
27,255 + 8,500 35,755
More.

508 x 100 50,800


6 = I .9 per cent
25,560 = 25,560

2,892 x l00_289,200
= 10.6 percent
27,255 — 27,255
More.

17 No (because the value of a good spouse can never be expressed in


monetary terms!)

18 cannot.

19 future profitability.

20 Incorrect.

How did you get on?

More than IS Excellent! Go on at once to the final chapter.


correct?
10- I 5 correct? You should read through the summaries of Sets 12,
13 and 14 before going on to the final chapter.
Fewer than 10 You should take a break and then return to Set 12
correct? again.

ISO
ASSESSING 7
THE BALANCE SHEET
7. SET IS. RELIABILITY
Estimated time: 25 minutes

Summary

A balance sheet offers useful information but how can we determine that
the data are reliable? We must check the internal consistency of the
balance sheet with the associated financial statements: the profit and loss
account, the sources and uses of funds statement, the auditor's certificate
and the notes to the financial statements.

The balance sheet and associated financial statements should show:


I. the name of the company and the date. It is important in assessing a
company's present financial position to see the latest balance sheet —
that is, one which is not more than six months old;
2. separate totals for the current and fixed assets and liabilities;
3. the basis on which the assets have been valued;
4. the director's signature, which indicates the acceptance of re-
sponsibility for the published figures, and a clear certificate from an
independent, professionally qualified auditor.

The balance sheet will probably not show:


I. whether the company, its directors and the auditor have a good
reputation;
2. ownership of a company's shares. If a few people own most of the
shares they may have great influence on the company, and it may be
important to consider their reputation;
3. that the laws of the country in which the company operates have been
complied with;
4. the extent to which generally accepted accounting and auditing
standards have been modified to comply with tax laws or to produce
conservative results.

5. the future operations, profitability and health of the business.


Overall, be cautious before accepting a balance sheet as a "true and fair
view" of the company's position.

'5!
How to read a balance sheet

IMPORTANT NOTE

The key to the balance sheet may often be found in the auditors
certificate and the notes to the financial statements.

152
_______
______

Assessing the balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. We have to be cautious about


right? Check below, accepting a balance sheet as a true
statement of a company's assets and

I 2. In this set we are going to look at


liabilities several ways in which we can get some
indication of whether or not a balance
is a reliable statement of a
company's financial position.

2
sheet

TIMBER PRODUCTS LTD.


Balance sheet

ASSETS LIABILITIES
Current assets 3 480 Current liabilities 2 870
Fixed assets 10 490 Fixed liabilities 4 350
Shareholders' funds 6 750
Total assets 13 970 Total liabilities 13 970

3. What should we look for on the


balance sheet itself? Up to frame 40 we
are going to be concerned with this
question.
Look at the very simple balance sheet
above. This is not a very informative
balance sheet; it gives very little detail.
There is also one very important thing
missing from it. This is the of the
balance sheet.

3 4. To assess a company's present


date financial position it is essential to see its
most recent balance sheet. If the balance
sheet has no you cannot be sure
that it is the most recent one.

153
_______________

How to read a balance sheet

CHECK FRAME YOUR ANSWER

4 5. It is equally important, of course,


date that a balance sheet should give the
of the company.

5 6. Before you accept a balance sheet,


name then, make sure that it bears the
andthe

6
name of the
company
date

JOHNSON MANUFACTURING CO. LTD.


Balance sheet at 31 December 1982

ASSETS LIABILITIES
Manufacturing tools Bank overdraft and
and stocks mortgage loan 50 600
of raw materials I 8 000 Accounts payable 8700
Land, buildings and Capital issued, earned
marketable securities 80 400 surplus, and loan
Finished products, from development bank,
customers' accounts repayable 1988 80900
and goodwill 41 800
Total assets 140 200 Total liabilities 140 200

7. Here is another simple balance sheet.


First look at the assets on this balance
sheet. The first entry is manufacturing
tools and stocks of

7 8. Manufacturing tools come under


raw materials [current/fixed] assets, and stocks of raw
materials are assets.

8 9. Now look at the second entry in the


fixed assets. Is this also a mixture of current
current and fixed assets?

154
Assessing the balance sheet

CHECK FRAME YOUR ANSWER

9 10. The current assets in the second


Yes item are the

10 II. In the third entry under assets


marketable there are two current assets and one
securities fixed asset. Which is the fixed asset?

II 12. By looking at this list of assets, is it


Goodwill possible to work out the value of the
current assets?

12 3. A balance sheet should always be


No set out in such a way that it is possible to
work out the separate totals of the
assets and the assets.

13 14. Now look at the liabilities on the


current balance sheet in frame 7. Would you say
fixed that these are set out in the clearest
possible way?

14 15. Look at the first entry under liab-


No ilities. Bank overdrafts are
liabilities, and mortgage loans are
liabilities.

15 16. Look at the third entry under


current liabilities. Capital issued and earned
fixed surplus are part of the
the long-term development bank loan is a
liability.

16 Il. By looking at this list of liabilities,


shareholders' funds could you tell the amount of the
fixed shareholders' funds? Could you
work out the total current liabilities?

'55
How to read a balance sheet

CHECK FRAME YOUR ANSWER

17 18. If you saw a balance sheet set out


No like the one in frame 7, would you accept
No it without question as a document that
would allow you to make a reliable
assessment of a company's position?

18 19. Look at the assets again. Can you


No tell on what basis they have been valued?

19 20. A reliable balance sheet will always


No indicate the basis of the of the
assets.

20 21. Fixed assets are normally valued at


valuation less
(The basis of
valuation may be
shown on the
balance sheet or on
notes attached.)

21 22. Current assets in the form of stocks


cost of materials and finished products are
depreciation normally valued at

22 23. Current assets in the form of mar-


cost or market ketable securities are normally valued at
value, whichever is but the should
the lower also be stated.

23 24. Customers' accounts are


cost assets. On the balance sheet the value of
market value the customers' accounts is [some-
times/never] reduced to allow for pre-
dicted "bad debts".

156
Assessing the balance sheet

CHECK FRAME YOUR ANSWER

24 25. The balance sheet (or the notes


current (or quick) attached) should always make clear the
sometimes of the of the assets.

25 26. It is also important that assets


basis should be valued on a constant basis from
valuation year to year. If the same assets are valued
on one basis at one date and on another
basis at another date, it is difficult to
the company's position at the
two dates.

26 27. Assets, then, should always be


compare valued on a basis. Otherwise, it is
to compare a company's position
at different dates.

27 28. Before we finish looking at the .

constant balance sheet in frame 7, suppose that


difficult you are assessing the company's position
in 1984.
If you were shown this balance sheet,
would you accept it as the most recent
balance sheet the company could
produce?

28 29. Why would you not accept this


No balance sheet as the most recent one?

29 30. To sum up so far, you can begin


Because it is dated to decide whether a balance sheet is
December 1982 acceptable by examining the balance
sheet itself.
The first thing to check is that it gives
the of the company and the
of the balance sheet.

•1 S.
How to read a balance sheet

CHECK FRAME YOUR ANSWER

30 31. Secondly, look to see whether the


name balance sheet is set out clearly. It should
date be possible to work out separately the
values of the different classes of
and

31 32. Thirdly, if you are comparing the


assets balance sheets of an enterprise at
liabilities different dates, make sure that the assets
are valued on a basis.

32 33. The on which the assets are


constant valued should always be indicated on a
balance sheet (or on notes attached).
If the assets have not been valued
according to the usual basis you may need
to inquire why this is so.

33 34. Now, in deciding whether the


basis balance sheet of a limited liability
company can be accepted without
question as a reliable statement, there are
two other things you should look for on
the balance sheet itself.
First, the directors of a limited liab-
ility company are responsible for the
preparation of the balance sheet, and
• they must sign the balance sheet to show
that they accept this

34 35. You should always make sure that a


responsibility limited company's balance sheet has been
signed by one or more of the

35 36. The balance sheet of a limited


directors company should be accepted with
caution if it has not been by one
or more of the

158
_______ _______
_______
_______
_______.
_______

Assessing the balance sheet

CHECK FRAME YOUR ANSWER

36 37. Secondly, look on the balance sheet


signed for a certificate from the auditor. The
directors balance sheet of every limited company
must be-examined by an independent
examiner (auditor). The then
certifies that the balance sheet shows a
true and fair picture of the company's
position.

37 38. Always make sure, then, that a


auditor balance sheet bears a clear from
the auditor.

38 39. The auditor is free to make corn-


certificate ments about the figures shown on the
balance sheet whether in the auditor's
certificate or by requiring additional
notes to financial statements. Therefore,
always read the certificate
carefully.

39 40. A balance sheet should be treated


auditor's with great caution if it is not by
one or more of the directors or if there is
no certificate from the What
about an auditor who is the manager's
uncle?

40 41. So far we have noted the things we


signed need to look for on the balance sheet
auditor itself in order to determine whether or
No (an auditor not it is a statement.
should be
independent).

41 42. But there are other factors which


reliable do not appear on the sheet that
also need to be taken into account.

159
How to read a balance sheet

CHECK FRAME YOUR ANSWER

42 43. Suppose you are looking at a


balance certain balance sheet.
It gives the name of the company, and it
is dated.
It is clearly set out, it lists the different
classes of assets and liabilities separately,
and it indicates how the assets have been
valued.
It is signed by two directors and
the auditor's certificate is attached; the
auditor has not expressed any reser-
vations about the figures.
The balance sheet is properly printed
and looks impressive.
On the basis of this evidence alone,
could you be certain that the balance
sheet is a reliable statement?

43 44. In addition to what is shown on the -

No balance sheet, you have to consider


factors outside the balance sheet before
you can be sure that it presents a reliable
picture.
Study also the profit and loss account,
the sources and uses of funds statement
and the notes to the financial statements.
Consider the factor of reputation. If the
company concerned has a long-
established for honesty and
efficiency, you can be fairly confident
about accepting its balance sheet.

44 45. Again, you can be fairly confident


reputation about accepting a balance sheet if you
know that:
(a) the who has examined and
certified it is properly qualified and
has a good reputation; and
(b) the who have signed it have a
good reputation.

160
Assessing the balance sheet

CHECK FRAME YOUR ANSWER

45 46. In other words, when deciding


auditor whether a company's balance sheet can
directors be accepted as giving a reliable picture
you may have to consider the reputation
of the the, and the
,

itself.

46 47. In some cases, the ownership of a


auditor company's shares may also be important.
directors If most of the shares are owned by a very
company small number of shareholders, these
people will probably have a great deal of
influence in the company, and it may
therefore be important to consider their

47 48. If the company, the directors and


reputation the auditor all have a high reputation, you
can probably assume that the law of the
country has been complied with. Many
countries have designed to
control company operations generally,
and various aspects of balance sheets in
particular.

48 49. For example, the law of the country


laws may specify the basis of the valuation of

The law may also control the rate at


which fixed assets can be or,

reduced in value.

49 50. In some countries, companies are


assets also obliged by law to put some of their
depreciated annual net profit into a "legal reserve".
This reserve is part of the funds,
but cairbe used only for purposes laid
down by

161
How to read a balance sheet

CHECK FRAME YOUR ANSWER

50 51. Normally, a balance sheet cannot


shareholders' be accepted as a satisfactory statement of
law a company's affairs unless it satisfies the
of the country.

51 52. To sum up, when you are deciding


law whether a particular balance sheet is
likely to be a reliable statement of a
company's affairs, you have to consider
factors shown on the balance sheet and
also factors ...........................................

52 You will soon be reaching the end of


not shown on the the book. Note the time you took to
balance sheet complete this set and the number of
frames in which you made a mistake.
Then read the summary for this set once
again before going on to the final set.

162
Assessing the balance sheet

7. SET 16. LIMITATIONS


Estimated time: 20 minutes

Summary

When we are making any assessment of a company's position, we must be


aware that the balance sheet can give only a limited picture of the
company's state of affairs. The greatest limitation of the information
contained on a balance sheet is that it is concerned only with things that
can be expressed in monetary terms.

A company's present financial position (as reflected in its latest balance


sheet) is important in determining its future potential. Equally important,
however, are factors such as the nature of the company's products
(especially in relation to expected technological developments), the skill
and morale of management and staff, the activities of competitors, and
general economic conditions. Such information must be taken into
account along with the balance sheet figures in assessing the future
prospects of a business enterprise.

The balance sheet is also limited because the figures which appear on it are
only estimates and not scientific facts. The key accounting concept is not
absolute accuracy but rather materiality; it is very difficult to value assets
exactly. Furthermore, unless special inflation accounting techniques are
adopted (see the technical note in Appendix A), a balance sheet assumes
that the value of money remains unchanged over time, which is certainly
not true.

Overall, be cautious, not only, as we stressed in the previous set, before


accepting a balance sheet as reliable but also before using the information
contained on it as an indication of the future performance of a business
enterprise.

Always study carefully the profit and loss account, the sources and uses of
funds statement, the notes to the financial statements and the auditor's
certificate. Determine if the auditor was professionally qualified, inde-
pendent, and adequately paid to complete a professional audit; check that
the auditor was able to complete the audit within six months of the end of
the financial year.

163
How to read a balance sheet

CHECK FRAME YOUR ANSWER

Is your answer I. Perhaps the most obvious limitation


right? Check below, of the balance sheet is that it gives an
incomplete picture of the state of affairs
of a company. It will always give an
incomplete picture because it is con-
cerned only with factors that can be
expressed in terms.

I 2. For example, the fact that a company


monetary has a number of strong competitors may
be a very important aspect of its position;
but this would never be indicated on the

2 3. Similarly, the company may be


balance sheet producing a product which will soon
be rendered old-fashioned, or even ob-
solete, by technological developments.
This too [would/would not] be reflected
on the balance sheet.

3 4. Again, the state of health of the chief


would not executive might be very important to the
company, but this would not be learned
from the balance sheet. None of these
facts could be expressed in

4 5. The balance sheet, then, gives an


monetary terms picture of the state of affairs of
an enterprise because it is concerned only
with things that can be expressed in

This is one reason why the


can never indicate how
successful an enterprise will be in the
future.

164
Assessing the balance sheet

CHECK FRAME YOUR ANSWER

5 6. The balance sheet may show the


incomplete resources available for the future, but
monetary terms the future success of the enterprise will
balance sheet depend on many factors including the
product, the skill of_______ and staff, the
activities of competitors, and general
economic conditions.

6 7. The first of a balance sheet,


management then, is that it gives an incomplete picture
of the state of affairs of the enterprise.

7 8. A second limitation is that the


limitation monetary values shown on the balance
sheet can never be completely exact and
accurate. Consider the values given to the
assets and those given to the liabilities.
Which are more likely to be accurate and
precise: the values given to the assets or
to the liabilities?

8 9. There will always be some Un-


The values given to certainty about the value of most of the
the liabilities of an enterprise. The value given
to them can never be exact.

9 10. Unsold stocks of finished products,


assets for example, are part of the
assets. They are usually valued at cost or
current market value, whichever is the

10 II. Suppose that unsold stocks are


current shown on a balance sheet at cost. Can the
lower company be certain of getting exactly this
amount of money when these stocks are
eventually sold?

165
How to read a balance sheet

CHECK FRAME YOUR ANSWER

I 12. Again, it is very difficult to know


No what the fixed assets are worth. These
are generally valued at with an
,

allowance for

12 13. The figures entered against the


cost fixed assets [are/are not] meant to rep-
depreciation resent resale value.

13 14. A balance sheet, then, never gives a


are not precisely accurate picture of the position
in monetary terms because the values
given to certain of the assets can never be

14 15. There is another reason why the


exact picture that is given in monetary terms
is never really accurate. Unless special
inflation accounting techniques are
adopted, the balance sheet assumes that
the real value of money remains constant:
in other words, then, a balance sheet as-
sumes that the real value of money
[changes/does not change].

15 16. Consider, for example, the


does not change long-term (fixed) liabilities. The figures
on the balance sheet are the amounts
borrowed: that is, the amounts that will
eventually have to be repaid. But when
the time comes for repayment, the real
value of this money is likely to be
[greater/less] than it was when the loan
was first made.

16 17. The balance sheet, however,


less usually assumes that the
of money remains constant.

166
Assessing the balance sheet

CHECK FRAME YOUR ANSWER

17 18. To sum up, one limitation of a


real value balance sheet is that it can take into
account only factors which can be
expressed in terms.

18 19. A second limitation is that the


monetary values shown for some of the assets will
never be

19 20. A third limitation is that very often


exact a balance sheet assumes that the real
value of money remains

20 21. In other words, we have to be


constant extremely cautious about using the
balance sheet as a guide to a company's
prospects.

21 22. Even when we have a correctly


future drawn up, signed and audited balance
sheet, where all concerned have a good
reputation, we need to pay careful
attention to other factors which cannot
. be reflected in the
figures themselves.

22 You have finally reached the end of the


balance sheet programme. Enter the usual data on the
Progress Work Sheet, and reread the
summary of this set before going on to
the mini-test on this final chapter.

167
_______
_______ _______ _______
_______
_______
_______ _______
_______

Assessing the balance sheet

MINI-TEST ON CHAPTER 7
Answer the questions below. When you have finished, check your
answers, and fill in the Progress Work Sheet as usual.

I It is often difficult to be certain that a balance sheet gives a true and


reliable statement of a company's affairs. The general rule is: always
be about accepting a balance sheet without question. A
balance sheet Imonths late is probably not
I

2 To help you decide about the acceptability of a balance sheet, you can
look at the balance sheet itself to see:
(a) whether it shows the of the company;
(b) whether it gives the of the balance sheet;
(c) whether it is set out in such a way that it is possible to work out
the values of the different classes of and
(d) whether it indicates the basis of the of the assets;
(e) whether there is a certificate from a professionally qualified

(f) whether it is signed by one or more of the


3 Other factors that you may have to consider are the reputation of the
of the , and of the itself.

4 Above all, before accepting a balance sheet as a reliable statement,


you have to be sure that it satisfies the of the country.
S The balance sheet gives an incomplete picture of a company's affairs
because it includes only those items that can be

6 A second limitation is that the values shown on the balance sheet for
some of the [assets/liabilities] will never be exact.

7 Thirdly, a balance sheet often assumes that the real value of money

8 On the basis of the balance sheet, can you judge how successful an
enterprise will be in the future?
9 The auditor should be p qualified, i , and adequately
p

10 The key to understanding data on the balance sheet is to read the


to the financial statements.

169
How to read a balance sheet

Answers to mini-test on Chapter 7

I. cautious reliable.

2 (a) name;
(b) date;
(c) assets; liabilities;
(d) valuation;
(e) auditor;
(f) directors.

3 directors; auditor; company.

4 law.

5 expressed in monetary terms.

6 assets.

7 remains constant.

8 No.

9 professionally; independent; paid.

10 notes.

How did you get on?

6 or more correct Excellent. Now read all the summaries and the
glossary in Appendix B before trying the final
quiz.
4 or 5 correct? Read through the summaries of Sets 15 and 16
once more before going on to the final quiz.
Fewer than 4 Take a good break and then work through these
correct? last two sets once more.

I 70
FINAL QUIZ

The following questions test the knowledge you have acquired from the
programme. Tick the most correct answer in each case.

I It is impossible to estimate all the figures on a balance sheet absolutely


accurately. Where there is uncertainty, the accountant drawing up
the balance sheet must:
o (a) guess the correct values
O (b) ask the union for more information
El (c) use his judgement to estimate the figures as accurately as
possible
El (d) leave the figures out, rather than put anything on the balance
sheet which is not entirely accurate

2 A balance sheet is a statement of the position of an enterprise:


o (a) over a period of years
El (b) over a period of months
El (c) at a particular date
O (d) between two dates
3 A balance sheet gives two main groups of figures, the:
El (a) owners' equity and shareholders' funds;
El (b) assets and liabilities
o (c) profits and the total finance employed
o (d) big and small
4 A balance sheet cannot include information:
El (a) about the value of a company's assets
o (b) the extent of a company's liabilities
0 (c) about money owed to shareholders
0 (d) which cannot be expressed in monetary terms

5 Those items which a company owns and which consist of cash and
things that will normally be converted into cash during the operating
cycle of the business are known as:
0 (a) current assets
o (b) current liabilities
El (c) fixed liabilities
0 (d) fixed assets

'7'
How to read a balance sheet

6 Assets which can be quickly converted into cash are known as:
o (a) shareholders' funds
o (b) unstable
o (c) quick liabilities
o (d) quick assets
7 Land and buildings, plant and machinery, fixtures and fittings and
motor vehicles all form part of a company's:
LI (a) current assets
o (b) fixed assets
o (c) quick assets
LI (d) liquid assets
8 Raw materials and work in progress form part of a company's:
o (a) current assets
LI (b) fixed liabilities
LI (c) quick assets
o (d) current liabilities
9 Which of the following do not form part of a company's assets?
LI (a) stocks of unfinished goods
D (b) shareholders' funds
LI (c) employee accounts
o (d) motor vehicles
10 Customers' accounts, employee accounts and other accounts out-
standing are usually valued at:
LI (a) the amount owed to the enterprise less provision for doubtful
items
o (b) the amount owed to the enterprise less depreciation
LI (c) cost + 10 per cent
LI (d) cost or current market value, whichever is the lower
Which group of assets would normally be valued at cost or current
I

market value, whichever is the lower, less provision for losses?


LI (a) quick assets
o (b) fixed assets
o (c) plant and machinery
0 (d) inventories

172
Final quiz

12 Which of the following assets are not normally valued at cost less
depreciation?
LI (a) motor vehicles
o (b) plant and machinery
LI (c) buildings
o (d) investments

13 A business enterprise's short-term debts are shown on a balance


sheet as:
LI (a) quick liabilities
LI (b) current liabilities
LI (c) owners' equity
LI (d) fixed liabilities

14 Fixed liabilities represent:


o (a) long-term finance
LI (b) cheap finance
LI (c) short-term finance
LI (d) worries for management

IS Except for bank overdrafts, current liabilities generally:


LI (a) should be reduced to a minimum
LI (b) should not be more than half the shareholders' funds
LI (c) should equal current assets
LI (d) do not involve the payment of interest

16 The "outside liabilities" equal:


LI (a) total finance — current liabilities
LI (b) fixed assets + fixed liabilities
LI (c) current liabilities + fixed liabilities
o (d) total liabilities — fixed liabilities

17 Which of the following is not part of the shareholders' funds?


0 (a) marketable securities
LI (b) issued capital
o (c) earned surplus
LI (d) capital surplus

'73
______

How to read a balance sheet

18 and are funds that have been


retained in the company and not paid to shareholders.
LI (a) cash in bank and employee accounts
o (b) fixed assets and current assets
o (c) earned surplus and capital surplus
o (d) current assets and issued capital
19 Profits made in the course of an enterprise's normal operationand
retained in the business are called:
LI (a) gross profit
LI (b) earned surplus
LI (c) operating profit
0 (d) capital surplus
20 Profits arising from the sale of fixed assets are called:
LI (a) operating profits;
LI (b) non-operating profits
LI (c) net profit before tax
LI (d) depreciation

21 Which of the following represent a company's most permanent


finance?
U (a) the fixed liabilities
U (b) shareholders' funds
U (c) goodwill
LI (d) manager's savings for retirement
22 The amounts reflected on the balance sheet for earned surplus and
capital surplus are the:
0 (a) amounts accruing during the previous financial year
0 (b) amounts accruing during the present financial year
0 (c) cumulative totals at the date of the previous balance sheet
LI (d) cumulative totals at the date of the balance sheet
23 Issued share capital will always be authorised capital.
LI (a) less than or equal to
LI (b) greater than
0 (c) less than
0 (d) greater than or equal to

'74
Final quiz

24 Balance sheets always reflect:


LI (a) a company's gross profit during a year's trading
LI (b) the uses to which profits have been put
LI (c) what a company owes and what it owns at a certain date
LI (d) an enterprise's obligations for the future

25 Dividends are paid to shareholders out of the:


o (a) current assets
LI (b) capital surplus
o (c) current liabilities
LI (d) earned surplus

26 Fixed liabilities are usually:


Li (a) short-term loans
LI (b) long-term loans
LI (c) bank overdrafts
LI (d) hard to move about

27 If a business enterprise's total assets are greater than its outside


liabilities, it is said to be:
LI (a) liquid
o (b) highly geared
LI (c) over-capitalised
LI (d) solvent

28 An enterprise is said to be liquid if current assets:


LI (a) are greater than they were on the previous balance sheet
o (b) are greater than fixed assets
LI (c) exceed current liabilities
o (d) include a large inventory of milk products

29 If a company has fixed assets of 10,000 WCU, fixed liabilities of 5,000


WCU, current assets of 1,000 WCU and current liabilities of 500
WCU, working capital is:
LI (a) 500 WCU
LI (b) 5,000 WCU
LI (c) 1,500 WCU
LI (d) 15,000 WCU

175
_______ _______

How to read a balance sheet

30 If a company has a (high) gearing of I : 5, what proportion of the


cost of assets is financed by shareholders' funds?

o (d) impossible to compute quickly

3I If a company has a (low) gearing of I I, then shareholders' funds


:

are borrowed money.


El (a) greater than
El (b) less than or equal to
D (c) equal to
o (d) less than
32 A statement indicating where new money shown on a company's
balance sheet has come from, and where money spent has gone to, is
called a(n):
El (a) profit and loss account
o (b) income statement
El (c) earned surplus statement
o (d) sources and uses of funds statement

33 Which of the following items would not be included on the sources"


side of a funds flow statement?
El (a) new issued share capital
0 (b) depreciation
o (c) new authorised share capital
o (d) new long-term loans
34 Which of the following items would be included on the "uses" side of
a sources and uses of funds statement?
o (a) decrease in working capital
El (b) increase in authorised share capital
o (c) depreciation
0 (d) increase in working capital

I 76
Final quiz

35 If a company's total assets were greatly reduced in value (because of a


fire, for example), the company might find that it was no longer
solvent. This would be the case if the company found that its _______
_______ now exceeded its total assets.
o (a) quick liabilities
o (b) outside liabilities
o (c) current liabilities
o (d) fixed liabilities
36 Which of the following statements is not true? The solvency ratio
indicates the:
o (a) difference between total assets and outside liabilities, expressed
as a percentage
D (b) relationship of shareholders' funds to total assets
o (c) relationship of shareholders' funds to total liabilities
U (d) relationship of long-term liabilities to short-term liabilities

37 Here is a table of assets and liabilities, expressed as percentages:

ASSETS % LIABILITIES %
Current assets 49 Current liabilities 25
Fixed assets 5I Fixed liabilities IS
Shareholders' funds 60
Total assets 100 Total liabilities IOU

The solvency ratio in the above table is per cent.


o (a) 25
LI (b) IS
o (c) 60
LI (d) impossible to work out without a micro-computer

38 If the solvency ratio has increased, this means that the excess of
_______ assets over outside liabilities has increased.
o (a) total
LI (b) current
o (c) fixed
0 (d) outside

177
_______

How to read a balance sheet

39 The ratio of current assets : current liabilities is the ratio.


o (a) quick
o (b) solvency
El (c) current
o (d) turnover
40 Quick ratio = :

current liabilities
El (a) mobile assets
o (b) fixed liabilities
o (c) quick assets
o (d) quick liabilities
41 The current ratio and the quick ratio are measures of:
El (a) solvency
El (b) liquidity
0 (c) management pressures
0 (d) gearing
42 Which of the following is the best indicator of how easily a company
can meet its current liabilities at short notice?
D (a) current ratio
El (b) solvency ratio
El (c) net profit after tax
o (cI) quick ratio
43 A company has current assets of 100 WCU, quick assets of 30 WCU,
and current liabilities of 150 WCU. The current ratio is:
El (a) 1.5:
El (b) 0.67 :

El (c) 0.2 :
El (d) impossible to work out from the given figures

44 A company makes a gross profit of 100 WCU, has operating ex-


penses of 33 WCU, has non-operating expenses of 17 WCU and
pays tax on its year's profits 13 WCU. The figure of 37 WCU
represents:
o (a) operating profit
El (b) profit before tax

I 78
Final quiz

LI (c) net profit after tax


O (d) transfer to capital surplus

45 For the company referred to in question 44, profit before tax


equals:
o (a) 50
LI (b) 62
o (c) 66
LI (d) 237

46 Which of the following are not deducted from the gross income from
sales in calculating a company's operating profit?
LI (a) cost of raw materials used in the goods sold
LI (b) wages of workers producing the goods sold
LI (c) wages of office staff handling accounts
LI (d) interest on mortgage loan on factory premises

47 Any of the net profit after tax left over after payment of dividends
is:
LI (a) used to pay wages of any non-salaried staff employed
LI (b) used to repay any long-term loans outstanding
LI (c) included in earned surplus
LI (d) included in capital surplus

48 Return on total investment and return on shareholders' funds are two


useful measures of:
LI (a) profitability
o (b) solvency
LI (c) liquidity
LI (d) a company's cost of borrowing

49 Return on total long-term investment is calculated by dividing profit


before tax ÷ interest on fixed liabilities by:
0 (a) shareholders' funds + fixed liabilities
LI (b) shareholders' funds + current liabilities
LI (c) shareholders' funds + owners' equity
o (d) the outside liabilities

'79
How to read a balance sheet

50 In calculating the return on total investment, "return" means:


o (a) net profit after tax ÷ interest on fixed liabilities
o (b) profit before tax + interest on fixed liabilities
o (c) profit before tax
o (d) net profit after tax

5I If a company has shareholders' funds of 10,000 WCU, has fixed


liabilities of 10,000 WCU, pays 1,000 WCU interest on fixed
liabilities, makes a profit before tax of 3,000 WCU and pays 1,000
WCU in tax, return on shareholders' funds expressed as a
percentage is:
0 (a) ID per cent
0 (b) 15 per cent
o (c) 30 per cent
o (d) 20 per cent

52 Using the figures given in question 5 I, the return on total investment


would be:
o (a) 20 per cent
0 (b) I 5 per cent
o (c) 25 per cent
o (d) 26.2317 per cent

53 In valuing an enterprise that is to be wound up, which of the following


balance sheet figures is likely to be particularly misleading?
o (a) current assets
0 (b) fixed assets
0 (c) current liabilities
o (d) fixed liabilities

54 In valuing an enterprise that is to be sold as a going concern, which of


the following figures will we not be able to get even from the most
recent balance sheet?
0 (a) the value of the current assets
o (b) future profits
D (c) long-term loans outstanding
El (d) trade accounts payable

180
Final quiz

55 Which of the following features is not essential on a well-drawn-up


balance sheet?
o (a) the age of the accountant drawing up the balance sheet
o (b) the name of the company to which the balance sheet refers
o (c) the date of the balance sheet
o (d) separate totals for current and fixed assets and current and fixed
liabilities

56 Before we can accept a balance sheet as a reliable and authentic


statement, we would want to see that it:
0 (a) has been signed by at least one of the directors and an external
auditor
El (b) has been stamped by the tax authorities
o (c) is attached to the previous year's balance sheet
o (d) is accompanied by a sources and uses of funds statement
57 Some factors cannot be shown on a balance sheet but need to be
taken into account in deciding whether or not a balance sheet gives a
true and fair picture of a company's position. Which of the following
is not such a factor?
0 (a) the reputation of the company's auditor
O (b) compliance with the laws of the land
0 (c) the reputation of the company and its directors
O (d) the true value of the fixed property of the company
58 In assessing a company's future potential, a balance sheet may not be
sufficient because:
O (a) it does not show how the gross profit was calculated
o (b) it does not include an income statement
El (c) it reflects only items which can be expressed in monetary
terms
El (d) fixed assets cannot be valued with absolute accuracy

59 Which of the following factors could be reflected on a company's


balance sheet?
o (a) investment in new machinery and equipment
o (b) expected future technological developments
o (c) the state of the country's economy
o (d) the market value of its fixed assets

18!
How to read a balance sheet

60 Which of the following is most correct?


O (a) a sources and uses of funds statement is necessary to determine a
company's profitability
O (b) a balance sheet gives only a limited picture of the money an
enterprise owes
O (c) fixed assets can be valued more accurately than current assets
O (d) a balance sheet is of limited value in predicting a company's future
profitability.

82
Final quiz

Answers to the quiz

1(c) 21(b) 41(b)


2 (c) 22 (d) 42 (d)
3 (b) 23 (a) 43(b)
4 (d) 24 (c) 44 (c)
5 (a) 25 (d) 45 (a)
6 (d) 26 (b) 46 (d)
7 (b) 27 (d) 47 (c)
8 (a) 28 (c) 48 (a)
9 (b) 29 (a) 49 (a)
10(a) 30(b) 50(b)
11(d) 31(c) 51(d)
12(d) 32(d) 52(a)
13(b) 33 (c) 53(b)
14(a) 34(d) 54(b)
15(d) 35(b) 55(a)
16(c) 36(d) 56(a)
17 (a) 37 (c) 57 (d)
18(c) 38(a) 58(c)
19 (b) 39 (c) 59 (a)
20 (b) 40 (c) 60 (d)

How did you do?

50 or more Excellent! Tomorrow you should start the tech-


correct? nical note on inflation accounting.
40 to 49 correct? Good. Now you should study the summaries again
and try the quiz a second time.
Under 40? You have probably learned quite a lot from the
programme but, in order to benefit even more,
perhaps you should wait for about a week and
then try to do the whole programme again fairly
quickly.

I83
APPENDIX A

Technical note on inflation accounting


This technical note is designed to give you both a general idea of the basic
concepts of inflation accounting and the opportunity to follow through, in
examples A-H, some of the complexities of the computations required.
The examples are more difficult than anything in the programme itself,
but when you make use of what you have learned from the programme in
your work, you may find it helpful to refer to this technical note.

First read the introductory section. Then study each example carefully.
You will find an explanation of the figures in the explanatory notes.

Inflation

Inflation is a constant increase over time in the general level of prices


which affects financial management decisions and accounting information.
Accounting seeks to measure economic events and changes over time
using monetary units, but during inflation the real value of such units
constantly changes. As long as the rate of inflation is small, it is practical to
ignore it; however, when the change becomes material (say, over 30 per
cent per year) then accounting data from one year to the next are not
comparable and can be misleading.

For instance, in Example B the profit and loss account shows a profit of
200 WCU which may have encouraged management to pay a dividend of
100 WCU for the year. However, when adjusted for inflation, the profit
of 200 WCU becomes a loss of 83 WCU. Thus, the dividend of 00 WCU
reduces the equity base (shareholders' funds) and the financial working
capital of the company.

Problems

Inflation affects profitability and financing for both external published


financial statements and internal financial reporting. While most
accountants agree that inflation must be adjusted for, there is no
agreement as to how it should be done or as to how valid and useful the
results are. The two basic methods for accounting for inflation are: GPPA
(General Purchasing Power Accounting) which uses one general
government index of retail prices and CCA (Current Cost Accounting)
which uses multiple price indices.

185
How to read a balance sheet

External financial reporting — GPPA method

For GPPA, all the items in a financial statement are calculated at a constant
monetary value using a general price index provided by the government
statistics office. Thus:
(a) the cost of fixed assets is adjusted for price changes from the date of
purchase to the date of the balance sheet; and depreciation is
calculated on the basis of the adjusted fixed asset cost;
(b) the opening and closing inventories are adjusted for price changes
from the date of purchase and the cost of goods sold is adjusted
accordingly;
(c) all profit and loss account items (other than cost of sales and
depreciation above) are adjusted to current price levels;
(d) the net monetary working capital (debtors less creditors) is adjusted
for price-level changes during the year.

The technique for these adjustments is objective but the general price
index may not reflect the real changes in fixed assets or inventory costs;
thus, GPPA adjustment may not reflect real profitability changes.
Furthermore, the GPPA depreciation charges may not provide for
replacement of fixed assets; accordingly, the financial statements
produced may be misleading and of little value.

External financial reporting — CCA method

Under the CCA method, more specific estimates or price indices


(computed by the government statistics office) are used for fixed assets
and depreciation (towards replacement cost), inventories and cost of
sales (towards changes in cost of materials). The technique of CCA does,
therefore, reflect more specific price-level changes, but it is more
subjective than the GPPA method and it has two major limitations:
(a) with technological change, fixed assets may not actually be replaced
with identical equipment; thus the comparable replacement cost of
old equipment may be irrelevant;
(b) loss of purchasing power of cash or near cash assets may, or may not,
be included as a relevant adjustment.

Overall, the CCA method provides an indication of the cost of replacing


fixed assets and inventories and is more relevant than the GPPA method.
However, it is complex and difficult for to under-
stand.

186
Appendix A

External financial reporting practice

Some companies in countries with moderate inflation may revalue fixed


assets to market value every five years; this increases assets and
shareholders' funds (revaluation reserve) and reduces the profitability
(due to increased depreciation charges). Some countries require inflation
accounting under both GPPA and CCA methods to be shown as
comparative data on normal financial statements.

Countries with high inflation (over 30 per cent per year) have introduced
a variety of measures to reduce the tax burden on inflationary profits;
however, where such tax laws differ significantly from generally accepted
accounting principles, the value of the resulting profit and loss accounts
and balance sheets is questionable.

Internal financial reporting

For internal financial reports where inflation is high (over 30 per cent
per year), traditional standard costing and budgetary control systems
become less useful because they are based on the false assumption of
constant price levels. This affects many internal management decisions,
particularly those based on evaluating profitability and the financing of
working capital needs.

To deal with these problems, management needs to forecast


systematically the long-term inflationary effects on inventories, fixed
assets and depreciation, and other costs, as they affect profitability and
financing. With high inflation, one year may be too long to maintain a
single standard cost or budget level for the existing cost and budgetary
control systems. Thus, it may be necessary to set up indices of price
changes and to adjust the historical cost systems quarterly; with
computerised accounting systems such complicated adjustments are
feasible.

Conclusion

All companies must modify their traditional accounting and control


techniques for high inflation (over 30 per cent per year) for both
published financial statements and internal reporting, but only
management can decide, by the usefulness of the result, what degree
of complexity is justified.

187
How to read a balance sheet

A simplified example of the CCA (Current Cost Accounting) method of


inflation accounting is given in Examples A to H. The example uses three
different price indices: equipment, materials and the general price level.
The GPPA (General Purchasing Power Accounting) method would be
similar but would use only one general price index.

Example A

BALANCE SHEET

/983 1983
Historical cost Current cost
ASSETS
Fixed assets
Cost/valuation 800 I 466
Less: Accumulated depreciation 280 533
520 933 (Ex. 0)
Current assets
Cash 100 100
Accounts receivable 500 500
Inventory 400 500 (Ex. H)
1000 1100
Total assets 1520 2033
LIABILITIES AND OWNERS'
EQUITY (shareholders' funds)
Current liabilities
Accounts payable 400 400
Fixed liabilities
Long-term loan 520 520
Owners' equity
Capital 100 100
Revaluation reserve 796 (Note)
Earned surplus 500 217 (Ex. B)
600 1113
Total liabilities and owners' equity 1520 2033

188
Appendix A

Explanatory notes

I. The balance sheet shows how the total assets increase from 1,520 to
2,033 because the company revalued fixed assets (520 to 933) and
the inventory (400 to 500).
2. Earned surplus is reduced by 283 (Example B) (from 500 to 217)
due to inflation adjustments.
3. Revaluation reserve is increased from 0 to 796 which consists of
revalued fixed assets 413 (Example D) and inventory 100 (Example
H), and profit and loss accounts adjustments 283 (Example G).

189
How to read a balance sheet

Example B

PROFIT AND LOSS ACCOUNT

1983 1983
Historical cost Current cost
Sales 2 500 2 500
Cost of sales 800 1800
Gross profit 700 700

Operating expenses 300 300


Operating profit 400 400

Current cost accounting


adjustments - 283 (Notes)
Adjusted operating profit 400 117

Income tax 200 200


Net profit (loss) 200 ( 83)

STATEMENT OF EARNED SURPLUS

Opening balance 400 400


Net profit (loss) 200 ( 83)
600 317
Less: Dividends paid 100 100
Closing balance 500 217(Ex. A)

190
Appendix A

Explanatory notes
I. The profIt and loss account shows how the profit of 200 is reduced to
a loss of (83) by CCA adjustments:
Depreciation increase 133 (Ex. D)
Cost of sales increase 250 (Ex. E)
Monetary working capital increase 20 (Ex. F)
Subtotal 403
Less: Gearing adjustment-offset of inflationary
losses by the debt: equity (long-term liabilities:
shareholders' funds) structure 120 (Ex. G)
Net CCA adjustment (above) 283
2. The closing balance of the statement of earned surplus is reduced
from 500 to 217 by the CCA adjustment of 283.

Example C

PRICE INDICES

1982 1983
End of Average End of Average
year year
Equipment 250 200 400 300
Materials 200 200 500 400
General price level 270 100 300 200

Explanatory notes
I. These price indices for equipment, materials and general price
changes for the years (982 and 1983 showing indices at the end of the
year and average indices.
2. The indices come from government statistical reports and are used to
adjust historical costs to current costs in Examples D to H.
3. Assumptions have been made so that only the end-of-year and
average indices for each year are used. However, other more
complex assumptions could be made.

191
How to read a balance sheet

Example D

ADJUSTMENT OF FIXED ASSETS

Historical cost (HC) Current cost (CC)


Cost Accumulated Cost Accumulated
depreciation depreciation
1982 Purchases 600 240 I 200 480
1983 Purchases 200 40 266 53
800 280 I 466 533

192
Appendix A

Explanatory notes

I. The adjustment of fixed assets shows how the net book value of fixed
assets 520 (800 less 280) is increased by revaluation of 413 to a net
book value of 933 (1,466—533) (see 4(c) below); it also shows how
depreciation for the year is increased by I 33 (293 — 160) (see 4 (d)
below).
2. Depreciation is computed as 20 per cent per year.
3. The indices come from Example C.
4. The detailed adjustments for CCA are:
(a) 1982 purchases — Cost:
400 (end 83)
600 (HC) x = I 200 (CC)
200 (average 82)

Accumulated depreciation:

240(HC)x 400(end83) =480(CC)


200 (average 82)

(b) 1983 purchases — Cost:

400 (end 83)


200 (HC) x = 266 (CC)
300 (average 83)

Accumulated depreciation:
400 (end 83)
40 (HC) x = 53 (CC)
300 (average 83)

(c) Revaluation reserve:


Current cost net book value (1,466 — 533) 933 (CC)
Historical cost net book value (800 — 280) 520 (HC)
Revaluation reserve 4l3(Ex. A)
(d) Depreciation 1983:
Current cost: 20 per cent x 1,466 293(CC)
Historical cost: 20 per cent x 800 l60(HC)
Depreciation increase l33(Ex. B)

193
How to read a balance sheet

Example E

COST OF SALES ADJUSTMENT

Historical cost
Closing inventory 500 (HC)
Opening inventory (previous balance sheet) ISO (HC)
Total increase (included in the calculation of
the cost of sales) 350 (HC)

Current cost at 1983 prices


400 (average 83)
Closing inventory 500 400 (CC)

400 (average 83)


Opening inventory ISO (CC)

Cost of sales — volume increase 100


Cost of sales — price increase 250 (Ex. B)
Total increase (included in the calculation of
the cost of sales) 350

Explanatory note

The cost of sales adjustment shows how the increase in inventory of 350
(500— I 50) is analysed into a volume increase of 100 and a price increase
of 250. This price increase of 250 is due to inflation and therefore is
adjusted on the income statement (Example B) as an inflationary
effect.

'94
Appendix A

Example F

MONETARY WORKING CAPITAL ADJUSTMENT (MWC)

Historical cost I 983


Accounts receivable 500 (HC)
Accounts payable 400 (HC)
Closing MWC 100
Opening MWC (Previous balance sheet) 50 (HC)
Total change

Current cost at I 983 prices


200 (average 83)
Closing MWC: 100 67 (CC)

200 (average 83)


Opening MWC: 50 (CC)

MWC volume increase 30


MWC price increase 20 (Ex. B)
Total change 50

Explanatory note

The monetary working capital adjustment shows how the net credit
allowed has increased during the year to 100 (500—400) from 50 (on the
previous balance sheet). This increase of 50 is analysed as a volume
increase of 30 and a price increase of 20. The price increase of 20 is due to
inflation and is adjusted on the profit and loss account (Example B) as an
inflationary effect.

195
How to read a balance sheet

Example G

GEARING ADJUSTMENT

Net assets are financed by:

Liabilities
Long-term loan 520 (Ex. A)
Less: Cash IOU (Ex. A)
Net long-term liability financing 420

Owners' equity (shareholders' funds)


Capital 100 (Ex. A)
Accumulated profit (before adjustment) 500 (Ex. B)
Revaluation reserves (before gearing
adjustment):
Fixed assets 413
Inventory 100 513 (Ex. A)
Net long-term equity financing H13

Proportion of inflationary changes financed by


long-term liabilities (debt) rather than
owners' equity:
420
= 27.39 per cent = approximately 30 per cent
(I 113 + 420)

Total inflationary adjustments 403 (Ex. B)


Gearing adjustment 30 per cent of 403
(approximately) 120 (Ex. B)
Net charge to income statement 283 (Ex. B)

196
Appendix A

Explanatory notes

I. The gearing adjustment shows how financing net assets with long-
term debt (420) rather than equity (I, 113) (i.e. with long-term
liabilities rather than shareholders' funds) enables the company to
pass on part (30 per cent) of the inflationary loss to long-term
creditors.
2. In this case the gearing effect shows how the debt : equity (long-term
liabilities
: shareholders' funds) structure (420 I 113) of the
,

company enables it to offset inflationary losses to the extent of about


30 percent; thus, only 70 per cent of the 403 inflationary adjustments
(depreciation 133, cost of sales 250, monetary working capital 20) is
appropriate to the company and a gearing adjustment of 120 (30 per
cent of 403) is deducted to show a net charge to the income
statement of 283 (403 — 120).

197
How to read a balance sheet

Example H

INVENTORY ADJUSTMENT

Closing inventory 400 (Ex. A)


Cost change from average 1983 to end 1983:
500 (end 83)
Cost: 400 500 (Ex. A)
400 (average 83)
Less: Historical cost (see above) 400
Revaluation reserve 100 (Ex. A)

Explanatory note

The inventory adjustment shows how the 1983 closing inventory of 400
valued at average cost for the year is revalued with year-end indices
by 100 (500 — 400), which is credited to the revaluation reserve
(Example A).

198
APPENDIX B

GLOSSARY

The glossary includes terms used in this book and other accounting
language which you might come across in the course of your work.
Alternative expressions are given in parentheses after the main entry.
accounting the technique of preparing financial statements from bookkeeping
records (based on accounting concepts such as those given below).
accounting concepts (accounting principles) practical rules which enable bookkeeping records
of transactions to be converted into financial statements. The rules
include concepts of cost, consistency, conservatism, comparability, going
concern, accounting period, matching, profit realisation, materiality, etc.
accounts payable (creditors) money owed by a business. Accounts payable appear on the
balance sheet under current liabilities.
accounting period the time interval from the date of one balance sheet to the next. The
period of the profit and loss account (usually one year).
accounts receivable (see customers' accounts)
accrual (liability, creditor, payable, current liability) an accounting concept:
income and expense for the accounting period, whether for cash or
credit, must be included. Revenues must be matched with appropriate
expenses to provide a meaningful net income figure for an accounting
period, regardless of when cash may have been exchanged.
accumulated a total amount by which the original cost of a fixed asset shown on the
depreciation balance sheet has been reduced to take into account deterioration and
obsolescence. For example, consider a water works that costs millionI

WCU. Each year depreciation of 50,000 WCU is recorded against it.


After five years its accumulated depreciation would be 5 x 50,000 WCU,
or 250,000 WCU. The main purpose of depreciation is to help set prices
so as to accumulate a fund that can be used to replace assets.
administrative cost of directing and controlling a business. This includes directors' fees,
expense office salaries, office rent, lighting, heating, legal fees, auditor's fees,
accounting services, etc. It is not a research, a manufacturing, a sales or a
distribution expense.
ageing an analysis according to time elapsed after the billing date (or due date) to
help management determine how to collect bills and to discipline
customers.
amortisation (similar to depreciation) the process of writing off the cost of an
intangible asset, such as a lease or patent, over its useful life. The
accounting process for amortisation is similar to the process of
depreciation for fixed assets.

'99
How to read a balance sheet

appropriation (see statement of earned surplus)


account
asset something owned by the business which has a measurable cost — fixed
assets, current assets or other assets.
asset back-up the realisable value of assets if the business is closed down; high value
reduces the risk of loss to a new purchaser of an old business and thus the
"downside risk" is low.
auditing critical investigation of the accounting records and internal controls of an
organisation. For many organisations it is a legal requirement that an audit
be carried out by an independent accountant before the annual accounts
of the organisation are issued.
auditor accountant who carries out an audit.
authorised capital (see capital authorised)
bad debt debtor who fails to pay. The amount is written off as an expense in the
profit and loss account.
balance sheet a statement of the assets owned by a business and of how they are
financed from liabilities and shareholders' funds. A balance sheet does not
indicate the market value of the business.
bonds (debentures) long-term loans, often secured on assets. These are not
current liabilities.
book value this can mean either (a) the value of assets in the books, the original cost
of fixed assets minus their accumulated depreciation; or (b) the value of
ordinary shares in the books (owners' equity less preference shares,
divided by the number of ordinary shares).
buildings these are classed as fixed assets, unless they are acquired for resale.
Depreciation on buildings over their working life is charged as an expense
in the profit and loss account. On a balance sheet they are valued at cost
less depreciation, not at market value. They are sometimes revalued
periodically. Land is not depreciated.
capital this has several different meanings: (a) share capital; (b) shareholders'
funds (net worth); (c) working capital; (d) fixed asset (as apart from
small fixed assets which may be treated as expenses); (e) assets of the
business.
capital authorised the capital stock which a company is authorised to issue by law. It may be
only partly issued for cash.
capital investment a large investment in fixed or other long-term assets.
capital Issued the capital stock actually issued by a company. On the balance sheet it
appears as part of the shareholders' funds. The price at which a share is
first sold by a company (normally the nominal value plus share premium

200
Appendix B

less share discount). It may be issued as ordinary, preference or deferred


shares.
capital reserve (see capital surplus)
capital stock (see share capital)
capital surplus capital profit which is not available for the payment of normal
dividends.
the money asset of a business. It includes both cash in hand and cash in the
bank. On the balance sheet cash appears as a current asset.
cash discount discount allowed to a customer for prompt payment of a debt, e.g. 2½
per cent discount for payment within ten days or net (no discount) for
payment within one month.
cash flow cash receipts and cash payments over a given period — the key to
liquidity.
chart of accounts a systematic fist of all accounts for a concern. A chart of accounts with a
description of their use and operation is a 'manual", or a 'book of
accounts", which is a main feature of a "system of accounts".
claims claims against the assets of the business. These may be owners' or
creditors' claims. Total claims equal total assets. Creditors' claims are
called liabilities. Owners' claims are called shareholders' funds or owners'
equity.
closing stock inventory at end of the accounting period. Part of the computation of the
cost of goods sold.
comparability an accounting concept: financial statements should be prepared
consistently so that the data are comparable.
company a legal entity, regulated by the Companies Act or the Corporation Act of
the country concerned. A company may be "limited" or "unlimited".
consistency an accounting concept (see comparability).
conservatism an accounting concept: financial statements should avoid overstating the
financial position. Profits are not usually recognised until they are realised.
Losses are usually recognised as soon as they are known.
consolidated financial statements for a group of companies as a whole with transactions
statements between subsidiary companies eliminated.
convention an assumption made in accounting. Many accounting concepts arise from
assumptions that have proved to be practicable.
corporation tax tax on the profits of a company.
cost this has several meanings: (a) expenditure on a given thing; (b) to
compute the cost of something; (c) a direct cost or an indirect cost (an
indirect cost is an overhead).

201
How to read a balance sheet

cost concept an accounting concept: assets are valued at cost not at market value.
Exceptions: (a) fixed assets are valued at cost less depreciation; (b)
current assets are normally valued at cost or market value, whichever is
the lower.
cost of goods sold (see cost of sales)
cost of sales the cost of the goods actually sold during the accounting period. It
excludes the cost of goods left unsold and all overheads except
manufacturing overheads. The cost of sales appears in the profit and loss
account. Sales less cost of sales equals gross profit.
creative accounting (see manipulation) a polite term for manipulation.
creditor (see accounts payable) a person or company who has supplied goods or
services but who has not yet been paid for them.
credit transaction a transaction which incurs (accrues) liability. No cash is paid or received
until later.
cumulative preference shares whose unpaid dividends accumulate until they are
preference shares eventually paid by the company. Some preference shares are specifically
non-cumulative.
current assets assets which are normally realised in cash or used up in operations during
one accounting period, normally one year. Current assets include cash,
debtors, inventory and prepaid expenses but not fixed assets or other
assets.
current liability a liability due for payment within one operating period, normally one
year. This does not include long-term liabilities or shareholders' funds.
current tax liability current liability for income tax which is due within one year (see also
future income tax liability).
current ratio ratio of current assets divided by current liabilities. A measure of
liquidity.
customers' accounts (accounts receivable, debtors) money owed to a business. Customers'
accounts appear on the balance sheet under current assets.
days of payables (see ratios)
days of receivables (see ratios)
debentures (see bonds)
debt capacity potential for borrowing more outside finance (related to gearing).
debtor (see accounts receivable) someone who has received goods or services
but has not yet paid for them.
deferred shares (deferred stock) shares of a company ranking for dividend after
preference and ordinary shares.

202
Appendix B

depreciation the reduction of the original cost of a fixed asset by a certain amount each
year over its working life. The amount is charged as an expense in the
profit and loss account. Land does not depreciate (see also accumulated
depreciation, depreciation expense, straight line depreciation and
diminishing balance depreciation).
depreciation depreciation (at cost) during the accounting period. This is not the same
expense as accumulated depreciation except in the first year of the fixed asset.
diminishing balance a method of depreciation which charges off the cost of a fixed asset by a
depreciation level percentage of the reducing balance over its working life. The
percentage remains the same but the depreciation charge decreases.
direct costs costs conveniently associated with a unit of product. Normally direct
labour, direct material, direct services (e.g. hire of equipment for one
specific job). All other costs are indirect costs, known as overhead
expenses. (Some cost accountants also use the term "direct" for specific
costs, i.e. overhead expenses which are clearly identifiable with an
overhead cost centre but not with a unit of product.)
director the officer of a limited company. A member of the board of directors. Not
a "partner".
discount (see cash discount, trade discount)
dividends that part of the net profit set aside for payment to shareholders; not an
expense chargeable in the calculation of net profit in the profit and loss
account; chargeable to the statement of earned surplus, it reduces the
balance of earned surplus declared by directors on the balance sheet. It is
not an automatic right of shareholders to receive dividends. A use of funds
(see sources and uses of funds statement).
downside risk risk of loss due to total business failure and subsequent liquidation of
assets to pay creditors and owners (see asset back-up).
dual aspect an accounting concept: two aspects of each transaction; the basis of
double-entry bookkeeping; debit and credit.
earned surplus (retained earnings, accumulated profit) the earned surplus available for
the payment of dividends. Part of the shareholders' funds.
earnings (income, profit, revenue)
entity an accounting concept: financial statements are prepared for a specific
entity. A shopkeeper, who personally owns his business premises, has
three entities and rewards:

203
How to read a balance sheet

Entity business owner Reward profit


landlord rent
employee wages
equipment asset if acquired for long-term use and not for resale. Equipment is
recorded on the balance sheet at cost less depreciation, not at market
value.
equity money provided by the owners; any right or claim to assets. An equity
holder may be a creditor, a part-owner or a proprietor.
expenditure money paid for a cost, an expense, an asset or other purposes. An
expenditure is charged against income in the period when that asset is
consumed to help generate that income.
expense expenditure properly chargeable in the profit and loss account. The
amount used up during the accounting period. An indirect cost. A
manufacturing, selling or administrative expense. Includes depreciation of
fixed assets. Expenses are 'matched" against revenues during the
accounting period to compute the figure for profit. (Note: purchases of
small, low-value fixed assets are often charged as expenses, in order to
avoid depreciation calculations and to show a conservative financial
position.)
face value (nominal value, par value) this is not the book (shareholders' funds)
value or the market value of shares.
financial ratios (see ratios)
financial statements the key statements are:
(a) the balance sheet;
(b) the profit and loss account;
(c) the statement of earned surplus;
(d) the sources and uses of funds statement;
- (e) the auditor's certificate and notes to the financial statements.
fixed assets assets such as land, plant and equipment acquired for long-term use in the
business and not for resale. Such assets are depreciated over their
working life. Fixed assets are recorded on the balance sheet at cost less
depreciation, not at market value. Sometimes they are revalued
periodically. Land is not depreciated.
fixed liabilities (long-term liabilities) liabilities not due for payment within one year (e.g.
bonds, debentures or loans). Holders are creditors and receive interest.
They are not shareholders.

204
Appendix B

fixtures and fittings miscellaneous office furniture and equipment. Such items are classed as
fixed assets if they are acquired for use and not for resale.
funds flow (see sources and uses of funds statement)
statement
future tax liability reserve for future income tax. Tax computed on the current year's profit
not due for payment until a future date. This normally becomes the
current tax liability in the following year.
gearing the ratio of shareholders' funds to borrowed money (4 : I means 20 per
cent borrowed (which is low); : 4 means 80 per cent borrowed (which
I

is high)). A "healthy" gearing ratio depends upon the industry


averages.
general expense an expense which is not a manufacturing, sales or administrative expense.
General expenses are sometimes grouped with administrative expenses in
the profit and loss account. They include auditor's fees, legal expenses,
etc.
general reserve part of the earned surplus set aside in the shareholders' funds section of
the balance sheet. It is not distributed as dividends. It is not an asset and it
is not cash. It is merely part of the shareholders' funds shown separately
on the claims side of the balance sheet.
going concern an accounting concept: all accounting reports and values assume that the
business is continuing and is not about to be wound up (liquidated). In
accounting, market values are therefore based upon those expected in
the normal course of business.
goodwill value of the name, reputation or other intangible assets of a business. In
accounting, goodwill is only recorded (at cost) when it is purchased. It is
not depreciated. It is often written off to nil. It is never valued at market
price. Generally it is a hidden asset of the business.
gross profit sales minus cost of sales. The profit computed before selling and
administrative expenses, etc., have been deducted.
gross profit .. gross profit
percentage measure of profitability: x 100 per cent.
net sales

income (earnings, profit, revenue) this is sometimes used to mean sales and all
forms of incoming benefits, not necessarily in cash. Money, or money
equivalent, earned or accrued in an accounting period.
income statement (see profit and loss account)
income tax liability (see current tax liability and future tax liability)

205
How to read a balance sheet

inflation accounting technique for adjusting normal (historical) financial statements according
to changes in price levels (see Appendix A).
intangible asset an asset which cannot be physically touched (may be shown separately or
as part of the fixed assets). Goodwill and patents are examples of
intangible assets.
investment amount invested in stocks, shares, bonds, debentures or any asset (see
also trade investments, marketable securities).
inventory stock of goods (including supplies) available for resale. Inventory is
valued at cost or market value, whichever is the lower, not at selling price.
Increased by purchases. Decreased by cost of sales. On the balance sheet
it appears as a current asset, not as a fixed asset.
issued capital (see capital issued)
issue price of a the price at which stock is first sold by a company.
share

land freehold or leasehold property owned by a business. Land is normally


classed as a fixed asset. It is recorded at cost, and it is not depreciated.
Sometimes land and buildings are revalued to market value. The
difference between cost and revaluation increases fixed assets and
increases capital surplus.
liability an amount owed by one person or organisation to another.
limitations of financial statments show a limited picture of a business because: (a) some
accounting important facts cannot be stated in monetary terms; (b) accounting
periods at fixed intervals involve uncertainty due to incomplete
transactions; (c) financial statements depend on concepts; (d)
accounting is not scientific, but depends upon judgement.
limited liability shareholders may risk losing all the money they have subscribed but they
company will not be liable for amounts beyond this. If a company could not meet its
outside liabilities, the shareholders could not be called on to provide more
money (in addition to what they had subscribed) to meet these outside
claims. In other words, the shareholders' liability is limited. The limited
liability company is one of the most common forms of business
enterprise.
liquidation the termination of a business whereby the assets are added up, the
liabilities are paid, and the balance is paid to shareholders.
liquidity the availability of cash or assets which can easily be turned into cash to pay
liabilities. Liquidity is measured by the:

206
Appendix B

current assets
current ratio = :

current liabilities
or the
quick assets
quick ratio = :

current liabilities
long-term liabilities (see fixed liabilities)
loss (deficit) the opposite of profit or income. Excess of costs and expenses over
income or sales. A loss reduces the shareholders' funds but may not affect
the cash balance.
loss on disposal of loss due to sale or disposal of fixed assets. Excess of fixed asset cost over
fixed assets accumulated depreciation, and scrap or sale proceeds. Treated as "other
income and expense" in the profit and loss account. Significant losses or
profits are sometimes charged to capital surplus.
machinery a fixed asset if acquired for use and not for resale. Machinery is valued at
cost less depreciation. Machinery manufactured or acquired for resale is
classed as inventory.
manipulation changes in values of assets and liabilities, using generally accepted
accounting principles, to produce higher or lower profit levels
(sometimes referred to as "creative accounting").
manufacturing overheads for manufacturing. Part of the cost of sales. It is not a sales or
expense an administrative expense.
marketable quick assets; investments easily converted into cash.
securities
materiality a key accounting concept whereby only "material" amounts are
important, and "non-material" amounts may be ignored. The concept
recognises that the balance sheet and associated financial statements are
only reasonable estimates and not scientific facts.
matching an accounting concept: costs and revenues in the accounting period
should be "matched" in order that the computed profit may be true and
fair. Matching means "appropriate to" not "equal to".
money an accounting concept: financial statements are limited because they can
only reveal facts about the business which can be expressed in monetary
terms.
mortgage long-term loan normally secured on fixed assets, usually property. A
mortgage is a long-term liability, not a current liability.
net this has two meanings: (a) figure after deduction (e.g. gross sales less
sales returns equals net sales); (b) payment of the full amount due with no
allowance for cash discount (e.g. 2½ per cent discount for payment
within ten days, net for payment within 30 days).

207
How to read a balance sheet

net assets assets less liabilities (see also return on investment, shareholders'
funds).
net income (see net profit)
net profit (net income, net earnings) profit for the accounting period after income
tax. The net profit increases shareholders' funds but does not necessarily
affect the cash balance.
net profit measures of profitability:
percentages
net profit
(a) net profit to sales: x 100 per cent
net sales
(b) net profit to shareholders' funds (return on investment):
net profit
x 100 per cent.
shareholders funds
Note: return on investment may appear to be high if the assets on the
balance sheet are significantly undervalued.
net worth assets less liabilities. The shareholders' funds (or owners' equity). The
balance sheet value of owners' claims based on accounting concepts. The
net worth does not indicate the market value of a business.
nominal value face (par) value of shares. Authorised and issued share capital on the
balance sheet shows the nominal value of the shares separately from any
premium or discount. The nominal value is not the book value or the
market value of shares.
non-operating expenses not directly related to normal operations, e.g. loss on sale of
expenses fixed assets, interest paid, etc. Significant losses are sometimes charged to
earned surplus or even to capital surplus.
non-operating income not arising from normal operations, e.g. profit on sale of fixed
income assets, dividends received, etc.
notes to the notes attached to the balance sheet and profit and loss account which
financial statements explain: (a) significant accounting adjustments; (b) information required
by law, if not disclosed in the financial statements; (c) changes in the
accounting concepts used to prepare the financial statements; (d)
exceptions to consistency with previous figures; (e) contingent liabilities;
(f) commitments. (Search here for evidence of manipulation.)
opening stock inventory at the beginning of the accounting period.
operating expenses all overheads of the business. Sometimes the term is restricted to mean
only selling, administrative and general expenses.

208
Appendix B

operating profit gross profit less operating expenses in the profit and loss account.
ordinary shares part of the shareholders' funds on the balance sheet. Holders are entitled
to dividends recommended by the directors. Not preference shares.
Possible values: (a) face or nominal value; (b) market value; (c) issue
price (including any premium); (d) book value (total shareholders' funds
less the par value of preference shares) (see also deferred shares).
other assets assets which are not fixed assets or current assets. Normally: goodwill,
research expenditure carried forward, trade investments, etc. Other
assets are valued at cost, not at market value, unless losses are
exceptional.
other creditors creditors or accruals for services. Not trade creditors for the purchase of
material and supplies. Other creditors appear under current liabilities on
the balance sheet.
overhead expense (overhead) an indirect cost which may be fixed or variable according to
the volume of production (see manufacturing, sales and administrative or
general expenses).
owners' claims (see shareholders' funds)
owners' equity (see shareholders' funds)
par value (see nominal value)
patent legal right to exploit an invention. A patent is classed as an intangible asset
on the balance sheet; it is recorded at cost less depreciation.
payable (account payable, creditor)
plant equipment and machinery. This is classed as a fixed asset if acquired for
use and not for resale.
preference share a share which entitles the holder to fixed dividends (only) in preference
to the dividends for ordinary shares. On liquidation, holders are normally
entitled only to the par value. Holders have no right to share in excess
profits.
preference stock preference shares in units.
prepaid expense an expense paid in advance for more than one accounting period.
Examples are prepaid rent or taxes and unexpired insurance pre-
miums.
profit (income, earnings) excess of sales over costs and expenses during an
accounting period. Profit does not necessarily increase cash — it may be
reflected in increased assets or decreased liabilities — but it increases
owners' equity. The term "net profit" sometimes means profit less
income tax.
profit after tax net profit. Profit before tax, less income tax for the accounting period, in
the profit and loss account.

209
How to read a balance sheet

profit before tax operating profit, less non-operating expenses, plus non-operating
income, in the profit and loss account. It is not net profit.
profit and loss (income statement) a statement showing sales, costs, expenses and profit
account for an accounting period.
profit and loss (see statement of earned surplus)
appropriation
account
profit realisation an accounting concept (see conservatism).
profitability (see net profit percentages)
provision this strictly means liability, but often has several different meanings:
(a) reserve, e.g. future income tax liability; (b) accumulation, i.e.
accumulated depreciation; (c) expense, e.g. depreciation expense;
(d) accrual, e.g. accrued expense, liability.
published financial balance sheet, profit and loss account, statement of earned surplus,
statements sources and uses of funds statement and notes to the financial statements,
with comparative figures and notes disclosing the information required by
law. They are less informative than internal statements (see also notes to
the financial statements).
quick assets cash, call loans, marketable securities, a commodity immediately saleable,
receivables. Quick assets are assets which can be made liquid in the
immediate future, such as within a month.
quick liabilities that part of the current liabilities that is due to be paid soon (e.g.
one month); not normally shown separately on the balance sheet.
quick ratio ratio of quick assets to current liabilities. A measure of immediate liquidity
(see gearing).
ratios useful indices of the financial health of an organisation. Healthy ratios are
developed from industry averages according to the size of the
organisation. Ratios include those for: (a) liquidity (quick ratio, current
ratio, solvency (gearing) ratio); (b) activity (assets. turnover
(sales/assets), inventory turnover (cost of days of
receivables ((receivables/sales) x 365 days), days of payables
(payables/cost of sales) x 365 days); (c) profitability (gross profit ratio,
net profit ratio, return on investment ratio).
receivable (account receivable, debtor)
recognition of profit an accounting concept: profit (income) is not recognised and recorded
until realised (in cash or debtors). By contrast, losses are recognised
immediately they are known. Profit is normally recognised when goods
are shipped to the customer, not when the order is received or when the
customer pays for the goods.

210
Appendix B

reserve this is a vague term. Strictly it means earned surplus (see also capital
surplus, provision).
retained earnings (see earned surplus)
retained profit (see earned surplus)
return on financial ratios are:
investment , net profit x 100
(a) return on shareholders funds =
shareholders funds

(b) return on total investment =


profit before tax + interest on fixed liabilities x 100
shareholders' funds ÷ fixed liabilities
revaluation sometimes fixed assets are revalued from cost to current values. The
difference is credited to capital surplus.
revenue (earnings, income, profit) sometimes it is also used to mean sales.
sale the price for which goods are sold; the total of amounts sold. A sale is
normally recognised when goods are shipped to the customer.
sales discount trade or cash discount on sales.
sales expense cost of promoting sales and retaining custom. Such an expense is an
indirect cost, an overhead expense. It is not a manufacturing,
administrative or general expense. Sales expenses include advertising,
sales publications, sales salaries, travelling expenses, depreciation of cars
used by salesmen, etc.
security (collateral) an asset pledged against a liability. Assets claimable by some
creditors in priority to others.
share a document certifying ownership of shares in a company. Share capital.
Part of shareholders' funds.
share capital (capital stock) part of shareholders' funds. Money put into a business by
the owners. Ordinary, preference or deferred shares.
shareholder owner of part of the share capital and shareholders' funds.
shareholders' funds (owners' equity, owners' claims) the amount due to owners of the
business. Shareholders' funds are increased by profits and reduced by
losses and dividends. (Assets less liabilities equals shareholders'
funds.)
share premium (stock premium) excess of original sales price of a share over its face or
par or nominal value.
solvency a situation where there are sufficient total assets to meet the outside
liabilities.

211
How to read a balance sheet

solvency ratio this is related to the gearing ratio; it is expressed as a percentage and it
shows the degree of risk. It may be measured in two ways:
shareholders' funds
(a) x 100 per cent
total assets

shareholders' funds
(b) x 100 per cent.
total assets less current liabilities

The first considers the relationship of shareholders' funds to total


liabilities. The second relates shareholders' funds to long-term liabilities
only.
sources and uses of (sources and application of funds statement, funds flow statement) this
funds statement statement shows the key financial management decisions for the
accounting period by indicating the sources of funds and the uses to which
the funds have been put. Sources are net profit plus depreciation, new
loans and new capital issued. Uses are dividends, the purchase of fixed
assets and increase in working capital.
statement of earned (profit and loss appropriation account, statement of accumulated profit,
surplus statement of retained earnings) a statement showing the earned surplus
brought forward, plus net profit, less dividends, to give the earned surplus
to be carried forward to the next year on the balance sheet.
stock usually means capital stock or shares (note that, in Europe and in the retail
trades, stock is also used to mean inventory).
stockholder (shareholder)
straight line depreciation method charging off the cost of a fixed asset equally over
depreciation the years of its working life (see also depreciation, diminishing line
depreciation).
subsidiary a company, of which the majority of shares are owned by another
organisation. The latter is the parent company.
tangible asset an asset which can be physically identified or touched.
trade creditor (see, accounts payable, creditor)
trade discount deduction from the selling price of an invoice because the buyer is in the
same trade as the seller. Not a cash discount.
trade investment investment in shares or debentures of another company in the same trade
or industry. This is a long-term investment, not a marketable security. It is
listed under 'other assets" on the balance sheet. It is valued at cost, unless
there is a substantial loss.

212
Appendix B

transaction a business event recorded in the accounts; a change in two items on the
balance sheet (a cash or a credit transaction). A transaction may be a sale,
a purchase, a cash receipt, a cash payment or an accounting adjustment.
Translated into debits and credits in the bookkeeping records.
true and fair an accounting concept: the balance sheet and the profit and loss account
show a "true and fair view" of the business, in accordance with generally
accepted accounting principles.
uncertainty limitation of accounting. Uncertainty at the end of each accounting period
makes it difficult to determine the "true and fair" position. Uncertainty
arises from: (a) incomplete transactions; (b) the market value of
inventory; (c) the working life of fixed assets for depreciation cal-
culations; and (d) the realisable values of assets; and (e) contingent
liabilities not yet known or calculable.
unpaid dividends dividends declared as due to shareholders but not yet paid in cash. These
are shown as current liabilities on the balance sheet. They are deducted
from earned surplus in the shareholders' funds.
value this has several meanings: (a) accounting value — value according to
accounting concepts, appropriate to the particular asset. Fixed assets are
valued at cost less depreciation. Current assets are generally valued at
cost or market value, whichever is the lower; (b) market value — realisable
value of inventory in the normal course of business (not on liquidiation);
and (c) real value — not known in accounting.
working capital (net working capital) current assets less current liabilities. Working
capital is not the same as capital. "Monetary" working capital refers only
to cash, receivables and payables.
working capital ratio (see current ratio)
work in progress work partially completed. Part of inventory, stock. Valued at
manufacturing cost or market value, whichever is the lower.

213
OTHER ILO PUBLICATIONS

Creating a market. An ILO programmed book


"This course deals with the planning and commercial aspects of marketing, mainly in the
consumer goods industries ... It is as lucid and logical an introduction to the often
complicated marketing process as can be found. Every student aiming for a Business and
Industry Management Diploma should regard this manual as a must." (Management,
Auckland)
"The reviewer can do nothing better than strongly advise the reader to read the book
carefully and go through the exercises. This will be a most profitable venture." (Social
Action, New Delhi)
ISBN 92-2-100082-6

Promoting sales: A systematic approach to Benefit Selling.


An ILO programmed book.
By Owen Dibbs and Patricia Pereira
The Benefit Selling method of marketing goods and services and selling ideas has proved
its fundamental worth time and time again. This book goes further than many other
courses on Benefit Selling: it develops a new, simple and practical approach to Benefit
Analysis which enables the reader to master Benefit Selling rapidly and surely, showing
what to do, how to do it and why the method suggested is so successful.
ISBN 92-2-1 01 393-6

Economics. A workers' education manual


One ofthe oldest mottoes ofthe workers' education movement is "Knowledge is Power".
For trade unionists, an understanding of economics is one of the essential forms of
knowledge. This manual is published in the beliefthat the first step in introducing workers
to the study of the subject of economics must be to prove that it is of direct relevance to
their working lives, and one which as trade unionists they would do well to investigate.
The manual therefore starts with a consideration of the workers' standard of living, in
terms ofjobs, pay, prices and social benefits, and then moves on to the subject of workers
and enterprises (types of enterprise, prices and markets, production, location of industry,
investment, wage determination and workers' access to management information),
before approaching what may appear to be the more remote subject of the national and
international framework within which workers and employers earn their living. The book
is written, as far as possible, in everyday language, and where abstract economic terms are
used their sense is clearly explained in the text and in an appended glossary of common
economic terms.
ISBN 92-2-1 03265 -5

Wages. A workers' education manual


The more trade union leaders and members know about what determines wage levels,
the causes of differences between wages in various occupations, industries and regions,
and the methods of wage payment (time-rates, piece-rates and bonuses), the more
effective will their action be in securing improvements, removing anomalies that are
unjustifiable and establishing proper wage structures.
This volume, consisting of 16 lessons, has been written mainly for use in study courses
attended by trade union members and other workers so that they may gain a clear
understanding of the issues involved. This is not a treatise on economics but a practical
tool that can be adapted to the widely varying circumstances characteristic of workers'
education,

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